22 March 2016

Hedge funds are some of the most misunderstood investment funds in the asset management industry. This is due to certain misconceptions which include alternative tools available to hedge fund managers and certain operational failures which would be labeled as hedge fund failures blowouts, these funds are perceived as risky with little investor understanding regarding how they are managed.

Despite the significant diversification benefits of including hedge funds in a balanced portfolio, gatekeepers to the South African industry, like consultants and Independent financial advisors find it difficult to explain to investors/trustees the methods employed by hedge fund asset managers how alpha is extracted and as a result the alternative investment space ends up being left out when constructing a portfolio for the majority of the South African institutional investor.

According to the Association for Savings and Investment South African (ASISA), as at December 2015 the Collective Investment Scheme (CIS) industry had R1,88 trillion under management, compared to the hedge fund industry which was R62 billion as at the same date. Keeping this in mind, it would be prudent that before delving into the benefits of including hedge funds in an overall institutional portfolio, certain perceptions about these funds (especially in the South African industry) be unpacked and critiqued.

The biggest (mis)perceptions about hedge funds are that they invest in risky assets and nobody knows or understands what the managers invest in or how they extract alpha from the market The fact is hedge funds invest in the same instruments available to traditional long only asset managers, the main difference being that hedge fund managers have more investment tools at their disposal like shorting and leverage to express their view on the market, resulting in an ability to generate an alternative source of return relative to traditional investments. Using shorting and leverage can introduce some risk into a fund, but if used appropriately these same tools can also be used to manage risk within a portfolio and enhance returns. Unlike most international hedge funds, when local hedge funds were introduced they were positioned more for the institutional investor and the emphasis was on using shorting and leverage within a fund to produce superior risk adjusted returns and protecting capital during market downturns.

According to HedgeNews Africa, that track and report on African hedge fund manager returns, the South African single manager hedge fund composite index, has proven over time that hedge funds returns have been less volatile and protected on the downside during market downturns. In addition according to the Novare Hedge Fund Survey, funds housing 58% of the industry assets provide daily transparency into their portfolio for investors, with an additional 30% providing monthly transparency. This represents about 90% of industry assets which is more than that of current CIS assets where quarterly transparency (with a month lag) is presently the norm.
There are a couple of factors to consider when looking at the impact of hedge funds in a balanced portfolio – whether the inclusion of hedge funds reduces risk, enhances returns and most importantly whether it improves the risk adjusted return of the entire portfolio.

The following table below shows historic annualized returns and risk statistics (April 2003 until December 2015) of the All Share Index, the All Bond Index, the HedgeNews Africa south African single hedge fund manager composite index and a simulated balanced portfolio (60% equities and 40% bonds).


EquitiesBondsHedge fundsBalanced
Ann. RoR19.0%8.8%13.9%16.0%
Ann. Std Dev (Volatility)15.8%7.0%4.6%12.1%
Max Drawdown-40.4%-9.8%-8.1%-30.6%
Sharpe Ratio0.880.551.920.91

Source and time frame: Inet, Hedgenews Africa data from April 2003 until December 2015

The graph illustrates the different risk/return profiles of the three indices and also demonstrates how a typical balanced fund is positioned. This graph makes it easier to see that in the local context, hedge funds have a different risk return profile to equities and bonds and that the volatility in monthly returns of hedge funds over that period has been lower than that of both the ALSI and the ALBI resulting in the Sharpe ratio being higher for hedge funds.

ENTER GRAPH HERE

The second table and graph then looks at what happens to a balanced portfolio when introducing hedge funds at different levels to the abovementioned balanced portfolio. The impact as hedge fund allocation increases is: decreasing standard deviation, improving maximum drawdowns, an enhancement in the overall annualized rate of return and consequently an improved risk adjusted return for the portfolio.

Exposure to equities60%55%50%45%
Exposure to bonds40%35%30%25%
Hedge Fund Exposure0%10%20%30%
Ann. RoR15.97%16.19%15.97%15.93%
Ann. Std Dev (Volatility)12.09%11.53%10.83%10.29%
Max Drawdown-30.55%-29.22%-27.84%-26.40%
Sharpe Ratio0.890.940.981.02

Source and time frame: Inet, Hedgenews Africa data from April 2003 until December 2015

According to the pension fund Regulation 28, which regulates pension fund investments in South Africa, pension funds can invest up to 10% of their total portfolio in alternative investments. This 10% limit was imposed primarily because most alternative investments, including hedge funds and private equity funds are not regulated.
Hedge fund managers are however regulated at manager level and need a category IIA licence under the Financial Advisory and Intermediary services (FAIS) Act. This is a special lisence category introduced in 2007 for hedge fund manager’s financial service providers.

To address the regulation of the hedge fund products, the South African Financial Services Board (FSB) together with National treasury and industry embarked on a consultative process to understand the industry better and put together a proposed hedge fund regulation which will see hedge funds regulated under the Collective Investment Scheme Control Act. Most hedge funds in South Africa operate as pooled investments, and it was decided that regulation should be in accordance with the existing Collective Investment Schemes Control, which regulates unit trusts. The main objective of the regulatory framework for hedge fund products, proposed by the National Treasury and the Financial Services Board (FSB), is the monitoring of systemic risk.

When this regulation is approved by government it will be hopefully encourage additional investments into the industry as the majority of the savings industry understands and are comfortable with the CIS structure and the additional regulatory oversight and risk management.

The proposed regulation has a big focus on risk management and compliance monitoring of the hedge funds with regular reporting to both the registrar and investors which should provide additional comfort for new allocations.

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