THE EVOLUTION OF THE SOUTH AFRICAN HEDGE FUND INDUSTRY AND WHAT IT MEANS TO FINALLY BE REGULATED

2 March 2016

The first hedge fund was founded by Alfred Winslow Jones in 1949 upon realising that he could effectively use two tools – short selling and leveraging – to protect his portfolio of shares in a falling market. Since then, the global hedge fund industry grew in magnitude and now encompasses multiple strategies intended to achieve solid risk-adjusted returns.

However, this has not always been the case, and there has been some bad press for the hedge fund industry due to a number of widely publicised mishaps. One of the most well-known hedge fund collapses is that of Long Term Capital Management in 1998, despite it being run by Nobel Prize-winning industry greats.

These incidents, along with the lack of knowledge about hedge funds, resulted in them being deemed as investment vehicles that use opaque strategies to produce returns (including black-box investing), coupled with excessive leverage. Many have even compared hedge funds to Ponzi schemes.

In addition, they are seen by many as elitist – unregulated entities only open to high-net-worth individuals or institutional investors. There is also the issue of limited transparency and liquidity, as some hedge funds impose lock-up periods on investors, ranging from 30 days to a year, depending on the fund’s strategy. Due to the unregulated environment, hedge funds were never allowed to market their product to the general public or solicit any money from the public. This was the case both locally and abroad.

However, despite the negative sentiments, hedge funds do offer lucrative investment opportunities, it just required a regulated environment. It was thus fitting when the regulations for hedge fund products were released in 2015. To understand the evolution of the regulations and where the South African market is today, it is important to understand where it started.

One of the first pooled hedge funds in South African was started in 1995. By 2003 the industry had grown to R2.3 billion and the Alternative Investment Management Association (AIMA) SA chapter was formed. The chapter was enacted due to the growing demand for SA hedge funds. In 2003 the first SA fund of hedge funds was created.

Fund of hedge funds gained traction over the years, and in 2007 the industry had grown to R26 billion. Of that, about 60% of these assets came from fund of hedge fund offerings. Due to the fund of hedge fund industry controlling most of the assets, certain minimum requirements were created for single hedge fund portfolios to minimise operational risk. Some of the requirements included the use of an independent administrator to value assets, the use of a prime broker (who was most often associated with a bank), a risk monitor, and sufficient human resources to oversee all of these service providers and manage the daily operational aspects of the business. During the same period the Financial Services Board FAIS department introduced an additional category license for hedge fund asset managers, in the form of a CATIIA. This special license category required managers to have previous hedge fund management experience as well as hold higher levels of capital adequacy requirements for the business.

SA hedge funds │ growth in assets under management

Source: Novare hedge fund survey 2015

From 2008 until 2011 there were minor increases in capital despite very strong returns from local hedge fund managers, due to offshore hedge funds having lost a significant amount of capital during that time frame.

In 2011 Regulation 28 was amended to allow pension funds a 10% allocation to hedge funds (this was previously not mentioned in Regulation 28). Despite this change there were minor changes in assets. From 2012 to 2015 the industry did experience some growth but most of this was due to assets in existing strategies delivering strong results and not due to new funds being launched.

In June 2015 the local hedge fund industry was worth a mere R62 billion compared to the local unit trust industry standing at R1.7 trillion rand. Hedge funds represented a mere 3.48% of the total CIS industry.

In 2015 National Treasury and the Financial Services Board released the final regulation of hedge fund portfolios after an extensive consultative process with the local industry. The new regulations would regulate hedge funds under the existing Collective Investment Schemes Control Act, No. 45 of 2002 (CISCA), which also encompasses the well-known unit trust industry.

The regulations will increase transparency between the hedge fund portfolio manager and the regulator. The hedge funds in the retail space will emulate those in the existing local unit trust industry, which local investors are familiar with.

The overriding aim of the regulations, therefore, is to ensure that hedge funds operate in a regulated space, which would lead to the development of financial markets to cater for different investor risk appetites. The regulation will also enhance investor protection and confidence while simultaneously monitoring systemic risk and enhancing the integrity of the industry. Enhanced reporting, disclosure, and transparency to the regulator and investor will also be required.

These regulations have made hedge funds available to retail investors for the first time, exposing them to the diversification benefits of these instruments. Hedge funds respond to different market conditions compared to traditional asset classes, hence resulting in low correlation to other asset classes. Therefore, including hedge funds in ones portfolio results in the lowering of the overall risk profile without compromising any long-term gains.

The availability of hedge funds to retail investors raises the key question as to how to determine an appropriate optimal allocation to hedge funds within a multi-asset portfolio. Regulation 28 provides a starting point to this decision with its provision for 10% of unit trust investments in local hedge funds.

In conclusion, investors who invest in a hedge fund should understand that they might not outperform the All Share Index, particularly in times of a bull market. However, by including a hedge fund allocation in a total portfolio they are investing into lower-volatility asset class diversification, capital preservation, and stronger risk adjusted returns.