2016 was a watershed moment for the South African Hedge Fund Industry. After many years in the making, the recently promulgated regulations have declared the business of hedge funds as that of Collective Investment Schemes (CISs). Thus, hedge funds are now governed by the same legislation as that of the well-established Collective Investment Scheme Act (CISCA) that governs the more colloquially known Unit Trust industry in South Africa.
Although now considered a CIS, the size of the hedge fund industry is dwarfed by the traditional CIS industry which recently breached the R2 trillion rand mark in assets under management. The Hedge Fund industry has shown measured growth, but is poised for acceleration with the introduction of these new regulations:
Hedge fund managers have been regulated by the Financial Services Board (FSB) since 2007, but by regulating the actual investment vehicle, this provides even more transparency and protection for investors. Two hedge fund structures have been approved:
Retail Investor Hedge Fund
Qualified Investor Hedge Funds
As the name suggests, Retail Investor Funds are readily available to the man on the street while Qualified Investor Funds will be restricted according to minimum investment size as well as investment experience.
What is all the hype about?
Hedge fund investing has been available in South Africa to institutional and high-net-worth investors since the early 2000s. The South African hedge fund industry has been a stellar performer, delivering good returns throughout this period, but importantly protecting capital during market downturns. Nowhere was this better highlighted than the market crash of 2008.
Period FTSE/JSE All Share Index Hedge News Africa Universe
2008 -23.2% -2.5%
2009 32.1% 16.1%
2008 – 2009 1.43% 13.2%
As can be seen by the above table, not only did the Hedge Fund Universe protect capital during the Sub-Prime Financial Crisis, but also managed to participate in the rebound, delivering a solid return over the 2 year period.
Hedge funds are often perceived and expected to produce super returns during all market conditions. It is imperative for investors to temper these expectations and focus on the following attributes hedge funds can bring to one’s portfolio:
Uncorrelated returns – adds diversification
The ability to conserve if not make money in falling markets
There are, however, higher octane funds out there that can produce extraordinary returns, but as the old adage goes “there is no such thing as a free lunch” and these funds are likely to be taking on excessive risk to produce excess returns.
Why Hedge Funds perform?
There is often a perception of hedge funds producing super-returns with esoteric strategies. Looking through the jargon and mysticism, the majority of hedge funds, especially in South Africa, follow strategies that are transparent and not as notoriously complicated as one may think.
Hedge funds essentially have two mechanisms that differentiate their potential return profile from that of their traditional counterparts:
Gearing is borrowing money to make investments over and above initial capital invested, also known as leverage. Gearing can be used to increase an investor’s exposure to a strategy, position or asset class to that of greater than their actual investment. Gearing will thus enhance returns, by way of example:
Investment Value R1,000
Investment Value plus gearing R1,000
Share Price on investment date R100
No of shares purchased 10
Share Price end of period R110
Profit at the end of the period R100
% Return on investment 10%
With Gearing (excluding the cost of borrowing)
Investment Value R1,000
Investment Value plus gearing R1,200
Share Price on investment date R100
No of shares purchased 12
Share Price end of period R110
Profit at the end of the period R120
% Return on investment 12%
As can be seen by gearing the investment, the return is enhanced from 10% to 12%. The corollary of a negative return will, unfortunately, also apply and negative returns are amplified.
Traditional funds can only make money when their investments rise and thus fund returns are often dictated by the direction of the general market (this excludes a fund managers stock picking capability).
Short selling is a strategy that allows hedge funds to make money when markets fall. Traditional fund managers have two outcomes for strategy implementation:
If they like an asset and believe the price will increase, they will purchase it
If they don’t like an asset and believe the price will decrease, they will not purchase it (often managers are compelled to hold an asset even if they do not like it as a result of mandate restrictions)
Hedge fund managers have a third option.
If they don’t like an asset and believe the price will decrease, they will implement a short selling strategy. The fund manager will sell the asset with the expectation of the price going down and look to buy the asset back at a lower price.
This gives hedge funds a distinct advantage of having the ability to deliver returns in all market conditions. The hedge fund manager will obviously still need to predict the correct direction of the market, but will not be hamstrung by only being able to deliver positive returns in bull markets.
Further Appeal of Hedge Funds
Although hedge fund structures have only recently become regulated, hedge fund managers have had strict oversight by the FSB. Managers need to qualify for a hedge fund specific license which includes, but is certainly not limited to a supervision period of three years under supervision, regardless of broader industry experience or qualifications.
Hedge fund managers in South Africa are highly qualified and experienced and have often gained their asset management knowledge in large corporates and institutions. This has certainly been the main driver of returns in the local hedge fund market.
As demonstrated earlier in the article, hedge funds manage significantly less assets than the traditional unit trust industry. This delivers a structural advantage to hedge funds, enabling them to be more nimble and decisive in moving positions around the market. Being smaller in size allows hedge fund managers to take advantage of the following:
Capture smaller market moves on a regular basis. Bigger funds will not be able to capture small moves as it is extremely difficult to enter and exit positions in the size they would need to in order to have a significant enough effect on overall portfolio return.
Exit positions in times of market turmoil. Bigger funds are often forced to ride out adverse market conditions because their positions are too big to sell timeously, even if a market correction is predicted. Hedge fund’s fleet footedness allows them to be far more reactive to news and market dynamics.
Reduced slippage on entry and exit of positions. Due to their size, large funds often impact the price of the asset when they are purchasing and selling investments. Entering or exiting positions for large institutions can often take months and even years. Hedge funds are able to execute their order entry timeously and at more desired price levels
Alignment of Interest
Hedge Funds businesses are often formed by individuals who have garnered experience in the asset management industry and have backed themselves to go on their own and build a successful business. Hedge funds charge management fees as well as performance fees. Due to the size of assets in the hedge fund industry being much smaller than that of traditional funds, earning asset management fees alone will not sustain these businesses. Thus it essential for these managers to perform in order to earn performance fees. These managers also often have their own capital invested side by side with investor capital, thus further aligning their interest with investors.
Less Constrained Mandates
Tradition mandates such as equity unit trusts have specific investment limits and guidelines that may constrain a fund manager’s subjectivity. Although the mandate restrictions are necessary to govern the risk associated with certain products and funds, the unintended consequence is that fund managers are often not able to express their ultimate investment view, and returns of these funds are dictated to by the direction of the general market.
Hedge fund managers have a lot more free reign. This can and does implement increased risk into portfolios, but it allows managers the freedom of choice and broader mandate to implement best ideas and themes into hedge funds.
Where to next?
We believe these are exciting times for the South African Hedge Fund Industry, as well as retail investors, who now have the opportunity to invest a portion of their investment portfolios into hedge funds.
If you are not an experienced investor, please contact PWH Wealth Group to guide you further in the process of exploring, understanding and hopefully ultimately investing in hedge funds. There are many diverse hedge fund strategies in the market, all with unique risk and reward characteristics. It is imperative that you find the appropriate balance in a fund that suits your particular needs.