We often highlight that hedge funds tend to perform better than traditional unit trust funds during bear markets and that hedge funds have a broader range of investment tools at their disposal. Rather than continuing to hammer this point (see what I did there), I thought it would be useful to explain some of the key differences using a football analogy.

What instruments can both use?

Both hedge funds and unit trust funds can invest in traditional asset classes such as equities, bonds, property, and cash or money market instruments.

In addition, both can use derivatives to hedge their portfolios. While hedging is common in hedge funds, it is generally used more selectively in unit trust funds, as excessive use can add complexity and increase costs without necessarily improving outcomes.

How does hedging work?

For the remainder of this newsletter, let's assume you are a die-hard Chelsea supporter. Your best friend is a passionate Manchester United fan, and the two of you are watching a match together.

Naturally, you want Chelsea to win. However, before the game starts, you agree that if Manchester United win, your friend will pay you R50.

Believe it or not, you have just created a hedge.

If Chelsea wins, you pay your friend R50 (you lose R50), but you are still happy because your team won. If Manchester United win, your team loses, but at least you receive R50 as compensation (you gain R50).

The hedge does not eliminate risk entirely, but it reduces the impact of an unfavourable outcome.

What can hedge funds do?

Now imagine that Chelsea is not even playing. Instead, the Champions League final is between PSG and Arsenal.

As a Chelsea supporter, you may strongly believe Arsenal will lose. You therefore decide to back PSG. This is no longer a hedge. It becomes an active investment view on an event that is unrelated to your existing position. In this example, the outcome of the match has nothing to do with Chelsea, meaning the PSG bet is a standalone position rather than a hedge.

This is one of the key advantages available to hedge funds. They can not only protect existing investments but can also seek opportunities by taking both positive and negative views on assets, sectors or markets.

Hedge funds can employ even more sophisticated strategies. For example, they may seek to profit from the expected number of goals scored, the number of yellow cards issued, or the relative performance of one team versus another. In investment terms, this is similar to using derivatives and other specialised strategies (like option structures) to generate returns from a variety of market outcomes.

What are the differences?

The biggest distinction is that unit trust funds generally need to maintain exposure to the assets they own.

Returning to our football analogy, a unit trust fund can support Chelsea and may use a small hedge to reduce the pain if Chelsea loses. However, it cannot build an entire strategy around Chelsea losing.

A hedge fund, on the other hand, can support Chelsea, bet against Chelsea, or ignore Chelsea altogether and look for opportunities elsewhere in the league.

This flexibility can be particularly valuable during difficult market conditions. If Chelsea is having a terrible season and keeps losing, the unit trust fund may be able to soften the blow through hedging, but it will still suffer because its primary exposure remains to Chelsea.

A hedge fund, however, can reduce or eliminate its Chelsea exposure and potentially profit from identifying stronger opportunities elsewhere.

Conclusion

Of course, investing is very different from gambling or sports betting, and this football analogy is simply a way of illustrating the different positions and tools that hedge funds can take.

Investment decisions are based on rigorous research, detailed analysis, and disciplined risk management. The objective is not to place bets, but rather to construct portfolios that can deliver the best possible risk-adjusted returns for investors across a range of market environments.

The greater flexibility available to hedge funds gives managers more tools to navigate challenging markets, which is one of the reasons they can often provide better downside protection and even an upside during periods of market stress.

Prepared by: John Henry Van der Westhuizen, Investment Analyst

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