The ins and outs of hedge funds
If carefully managed and regulated, they can be a valuable part of an investment portfolio, writes
Recently Boutique Collective Investments hosted a conference of many of the fund managers on its platform. I have decided to focus on the subset consisting of hedge fund managers.
There are two reasons for this somewhat narrower focus than usual first, hedge funds are not a very well covered or understood asset class and, second, there have been some recent technical but important changes in legislation about allocations to fund managers.
The panel dealing with the subject was asked what the right allocation to hedge funds would be for either annuity or equity clients. The reply was that under regulation 28 (which governs retirement products) there was a 10% allocation, with maximum 5% to a fund of funds or maximum 2.5% to individual funds. The comment was made that there is no cap in the case of living annuities; allocations could be higher, preferably with a split across a selection.
Now, quite obviously, some of that was fund managers talking their own book, but, given the nature of hedge funds, it was rational, considering the much wider array of strategies occurring in hedge funds as opposed to regular long-only investments.
Investments in hedge funds are tightly regulated, in the best interest of all investors. However, because the creation of law is convoluted and often messy, there was an unintended regulatory mismatch between regulation 28 of the Pension Funds Act and the Collective Investment Schemes Control Act.
Regulation 28 allows pension funds to invest in hedge funds because of their merits in generating smoother return profiles for investors. However, the Collective Investment Schemes Control Act did not specifically name hedge funds as allowable assets when promulgated, because hedge fund regulation was promulgated only later.
Pension funds were allowed to invest in hedge funds under regulation 28, but regulation 28-compliant funds were not allowed to.
The Financial Sector Conduct Authority intends to allow funds to invest in retail hedge funds, subject to the same limits that apply to pension funds in terms of regulation 28 and provided
that the retail hedge fund prices and repurchases daily. Once this amendment is promulgated, many multiasset high equity, medium equity and low equity unit trust funds will be able to invest in hedge funds, up to 2.5% in a single hedge fund, 5% in a fund of hedge funds and a total allocation of 10%.
Now, hedge funds have a bad reputation but, quite frankly, a lot of that bad reputation is due to poor regulation in the past, and a Wild West approach that used to be allowed particularly in the US.
Properly and prudently managed and regulated hedge funds can be very helpful in providing a wider toolset to navigate treacherous market volatility by reducing the overall risk of the portfolio, minimising drawdowns and generating a smoother return profile for hard-earned savings.
To understand the ecosystem these hedge fund managers form part of, compare the HedgeNews Africa indices with, say, the all share index (Alsi) on a risk/return basis. You will see that the Alsi funds are much
more clustered on a risk and return basis than hedge funds. This demonstrates how the wider and more flexible mandates of hedge funds (relative to traditional peers) play out.
Within the hedge funds there are wide dispersions because the opportunities targeted by different hedge funds are so diverse. Hedge fund managers tend to be very focused, and this takes us back to the good sense of the earlier comment about diversifying widely across hedge fund managers.
I haven’t seen one South African fund cover the entire opportunity set, and investors really should diversify across a selection of opportunities in hedge funds. Traders have a word for this it’s called “position sizing” (in other words, small relative positions cannot kill you).
Just as equity funds and balanced funds have characteristics that differentiate them as distinct investment opportunities, hedge funds also have merits.
The graphics here compare the HedgeNews Africa indices of hedge funds (long-short strategy funds, multistrategy funds and quant and neutral funds) with the Alsi and the all share total return index. As you can see, the inclusion or exclusion of dividends matters a lot.
Hedge funds are variable in terms of dividends they pay, and the charges that are incurred. Accordingly, I’m not so much posting these to illustrate a neck-and-neck return race as to show the risk mitigation properties of hedge funds in portfolios.
Taking the data and turning it into a debate could be quite a convoluted exercise, but there are a few observations to make. First, the gap between the index and the total return index illustrates just how important dividends are to the overall return profile. The risk mitigation properties of an index of hedge funds to an equity (or other) portfolio becomes apparent in these graphics.
My understanding is that these are even weighted, which makes sense from an illustration point of view (a market weighted approach would cause distortions, whereas we are trying to illustrate how diversity of strategies has merit). As you can see, all of the hedge indices did well in bridging the volatility chasms of 2008, 2018, 2020 and the past year.
Philosophically speaking, I believe that the diversification benefit from hedge funds arises both as a numeric function of their opportunity sets and due to the mindset in terms of managing such a fund. Even highly active traditional long-only funds will still have to take a view to ride their mandated assets, come what may. This means that these funds will take marketrelated pain when and if equities and/or bonds fall.
Some hedge funds could take an accentuated view of such market perspectives while others may attempt a more market conditionagnostic approach (the latter is known as an absolute return approach, in which funds try to grind out a return in all market conditions).
Comparisons may be odious, but think of a traditional long-only portfolio as a sailing ship that is persistent but must work with currents and winds, whereas hedge funds are more like a motorboat — in other words, they can go against currents and winds and are generally nippier, but they can also run out of fuel or crash harder, as the case may be.
These widely varying approaches mean that it’s both important that you understand what hedge fund managers are doing and that they are consistent in what they say they are doing. A long-only fund that goes down less than the market may have performed well, but a hedge fund with an absolute return mandate will have clients who cannot eat relative performance.
Traditional long-only fund managers can use equities, bonds and cash in their unit trusts; hedge funds can use all of these, plus multiple derivatives such as options, futures and gearing funded via shorts.
Most long-term investors
will correctly believe that over time they will make inflation-beating returns out of well-diversified long-term investment portfolios. Because of this truism, most investors will fail to realise that a great deal of that return will be derived from a relatively narrow grouping within the portfolio. Many individual equities will display what statisticians would call a high negative skewness, namely that many individual shares will give quite tepid performances. This is one of the reasons indexing is such a successful strategy — it’s not that it’s particularly clever, but it captures all performances. This also means there is a huge array of potential shorts a hedge fund manager can use.
Why this is particularly relevant in the case of the
JSE? It is certainly pertinent in the case of South Africa Inc. The graphic from Anchor Capital shows how South Africa Inc (as represented by the capped shareholder weighted index) has been beaten thoroughly on a riskadjusted basis by cash (in fairness, this does exclude tax friction). The South African economy has been stuck in a low-growth trap for years, with the result that many sectors are in a zero-sum game where you have one winner and many losers. Picking the champion and benefiting are often easier said than done, but the facility to go short means that you have more possible ways to try to exploit the situation.
Local investors are extremely fortunate that about 70% of the JSE is actually a semi-offshore market, either because the big caps are duallisted or because they have substantial export earnings that benefit from a collapse in the currency. Without this dynamic, many South African retirements would have been decimated in the past 10 years.
I have to say that while this range may be fairly wide in market capitalisation, it is somewhat limited in terms of breadth, which could in future reinstitute the hothouse effect that was such a problem on the JSE from the 1970s to the 1990s. While there is no evidence that this is a problem now, if it does arise again, I would look to hedge funds to mitigate my risk.
Further to that I should also comment that the JSE indices are strange animals, an example being that Richemont is fully weighted in the JSE Alsi while, until recently, only 12.5% of its market capitalisation was represented by depositary receipts actually traded on the JSE. This inevitably meant that there would be a mismatch between what was held by South African institutions on behalf of clients and what they could feasibly hold. This, of course, is why the 45% offshore allocations available to institutions are so important, as they prevent any actuarially unsound distortion on our national retirement portfolios universe.
It used to be a truism that South Africa was historically the highest returning equity market in the world, not because we had any superior attributes but because we went from pariah to “sainthood”. The trouble is we now have a national determination to behave like a cross between a muppet and a villain. The result is a demolition derby in our equities as they start narrowing in on the kind of risk premiums you would expect to find in autocracies such as Russia or China.
Accordingly, if the government keeps playing footsie-footsie with the Russians, instead of fixy-fixy with our power infrastructure, international markets will keep derating South Africa and our cost of capital will keep rising until the pips squeak.
I will not go into the specific arguments raised in any particular depth; suffice it to say hedge funds are capable subset offerings of already credible long-only fund management operations.
I am indebted to Elmien Wagenaar of Think Capital, Cy Jacobs of 36One, Clarissa van der Westhuyzen of Fairtree, Liam Hechter and Henry Biddlecombe of Anchor and Ofri Kahlon of Visio for access to notes and slides.