Australian cricketing twin brothers Mark and Steve Waugh have endured a range of nicknames. Steve, who was picked for top teams earlier than his brother was called “Drobe” (as in wardrobe) while, so the story goes, brother Mark had to contend with the name “Afghanistan”; named for the lesser known war (Waugh). Hedge funds that are mandated to provide investors with income are the Afghanistan of the hedge fund industry.
Over the years Rosebank Wealth Group has developed close relationships with many stakeholders in the hedge fund sector. We are convinced that hedge funds, with their different set of underlying tools, have an important role to play in contributing to capital preservation, income provision or capital appreciation for ordinary investors.
We believe that in the future a greater proportion of ordinary investor assets will be invested in hedge funds, and want to educate investors as to how best to do this.
We would suggest that an appropriate investment vehicle for investors wishing to explore ways of gaining exposure to hedge fund strategies might be to choose a hedge fund of funds. The choice of a good fund of hedge fund, which capitalises on different hedge fund strategies, offers the benefit of diversifying risk across different fund managers and their strategies.
Hedge funds mandated to provide investors with an income have a particularly important role to play for cautious investors. We have found that the merits and value of the funds in this sector are not as appreciated as they should be.
The 12th edition of the Novare Investments South African Hedge Fund Survey’ which includes the details of 53 asset managers who collectively manage over 111 hedge funds, valued the South African hedge fund industry at just over R62 billion in July 2015.
The survey showed that nearly 60% of hedge funds use an equity/ long short strategy to manage funds and that the “fixed income strategy” represents 14.1% of assets, “market neutral strategies” about 9% and the balance is “other”.
Fixed income funds are designed for people who wish to maintain their capital and require their invested assets to generate an income. The term “fixed income” is a misnomer in that the yields generated are not actually fixed; the objective of most fund managers is to seek high yields from interest bearing investments while taking on acceptable risk. Faced with the same problem the unit trust industry has switched to the term “interest bearing”.
In the traditional unit trust environment, there is a greater level of investor demand for investments that include interest bearing investments as underlying holdings. Interest bearing assets are underlying holdings in three ASISA categories. These include money market funds (16% of total assets), assets in the interest bearing category (8%) and assets in the multi asset category (7%).
The assets in the interest bearing category can be on one of two sub categories; interest bearing: variable term, which has 3% of total assets and interest bearing: short term, which has 5% of total assets. The multi asset income category has 7% of total assets with R126.3 billion.
International research from a range of sources including UK-based Alternative Investments Management Association, (AIMA), which celebrated its 25th anniversary last year expect that there will be a “significant shift” in hedge fund manager primary sources of capital over the next five years. They expect to get new flows from both pension funds and retail funds, as the economic investing environment becomes less predictable.
This view is supported by two management consultant reports; KPMG International published a report called Growing Up — A New Environment for Hedge Funds and a PwC report, Alternative Asset Management in 2020. Both of these documents reported that they expect greater inflows for alternative investments, including hedge funds, over the next few years.
Getting to know the fixed income hedge fund sector
Many retail investors have the impression that because historically hedge funds were not regulated by the Financial Services Board (although hedge fund managers were), they could chop and change their investment strategies to take advantage of prevailing conditions.
While strictly speaking this may have been possible, in practice it was rare as the investors in many hedge funds are institutional investors. Institutional investors (mostly pension funds and insurance companies) give hedge fund managers strict mandates, not only in terms of performance targets, but the risk parameters that hedge fund managers must operate within, in order to reach required targets.
Unlike conventional unit trusts hedge funds can use derivatives and leverage to achieve their investment objectives. However, derivatives that are used should have a value that can be reliably valued. Hedge funds that seek to provide income have access to a wider range of underlying instruments and strategies.
According to Erik Nel, manager of the Terebinth Fixed Income Macro Hedge Fund, fixed income hedge funds, generally speaking, have a more limited tool set than that of multi asset income or even flexible income long-only managers. He says that the vast majority of hedge funds are pretty much restricted to money market, bond, swap and Forward Rate Agreements (FRAs).
“Only a very few are allowed pure foreign exchange and maybe two or three invest in listed property. None that I am aware of are allowed to go offshore. The key differentiator (or to my mind reason why an investor would want to invest in both a long only and hedge funds) is that hedge funds are allowed to ‘go short’.”
“Furthermore”, says Nel, “it is not appropriate to compare the performances of hedge funds in the fixed income interest category with that of long only unit trusts in the flexible income sector.
“This is because hedge funds have all their holdings marked-to-market by independent prime brokers daily, including all their money market holdings. This does not happen in the long-only space; these holdings are marked on a straight line accrual basis. Therefore, if you consider that a long-only flexible income fund could easily hold 10-30% of its assets under management in bank negotiable certificates of deposits (NCDs) and floating rate notes on a straight line accrual basis. While the hedge fund that it might be compared against, sometimes makes use of leverage by buying for instance, the NCD and pledging it as collateral and can have up to 100% of his capital and have his NCD marked to market. You can appreciate how much more volatile the latter is purely on this measure alone.’
“For me fixed income hedge funds are a complimentary tool to fixed income (long only) funds and should not be seen as competition,” he said. “At about R126 billion, the flexible income category (ASISA SA MA Income) is around 10 times the size of the fixed income hedge fund industry. And this only captures retail assets. Segregated mandates can at least double this. It is not appropriate to see us as competition. The return signature, over time, of fixed income hedge is different to that of flexible income, with very different risk characteristics.”
HedgeNews Africa, a well-known hedge fund website reports on the performance of fixed income hedge funds in two sectors, the South African Fixed Income category, in which there are 13 funds, and the “Fund of Funds” sector in which there are a further six funds which have the words income provider or similar in their name. Some of the hedge fund of funds blend hedge funds with long only unit trusts to make up their “Fund of Funds” portfolios.
In the next article in this series we will look at some of the leading income providing funds in both the long only sector and the hedge fund sector.