The South African hedge fund industry is still relatively small. There is only around R70 billion invested in local hedge funds, which makes it a tiny part of a $3 trillion global industry.
In many developed markets, hedge funds are a key part of the portfolios of most large pension funds. They are widely used to lower portfolio volatility and reduce the risk of big drawdowns.
Locally, however, the level of uptake is still modest. There is generally a low level of awareness of what these products do and what their benefits are.
“Over the last eight years the average South African long-short hedge fund has had a similar return to the JSE All Share Index (Alsi), but with half the volatility,” says Murray Winckler, co-founder of Laurium Capital. “The downside has also been protected way more.”
He points out that during the financial crisis, over a period when the Alsi was down 31.8%, the average local long-short hedge fund was only down 8.9%. In comparison, the average Regulation 28 compliant balanced fund was down 11.1%.
This is what makes these products appealing. The best of them are able to capture market-related returns, but at much lower risk.
Until recently, however, very few people would have been aware of how local hedge funds have performed. This is because managers were not allowed to market their products, as they fell outside of any regulatory framework.
That has now changed with hedge funds being included under the Collective Investment Schemes Control Act (CISCA). This means that they are now treated in much the same way as unit trusts.
Over the course of last year, all hedge funds in the country had to apply to the Financial Services Board (FSB) to be registered. Through that process, the regulator approved 112 portfolios as appropriate for retail investors.
These products are slowly coming to market, which means that anyone can now invest directly in a hedge fund. In order to protect these investors, these funds are also quite restricted in what they can do.
“These retail hedge funds are aimed at a hitherto untapped market – being the man on the street,” explains the FSB’s Udesh Naicker. “There is a presumption that this market will have less of an appetite for risk, and so we have limited the kinds of exposures that these funds can take on, and how much gearing they can employ.”
What this means is that it should not be possible in these funds to take extremely risks positions that could lead to major losses.
“We are also being very specific about what these funds have to disclose to investors and to us on an ongoing basis,” Naicker adds. “When you buy into a fund you need to know what is the maximum level of gearing it could assume, what types of instruments is it allowed to invest in, and what kinds of fees that are charged. We want to make sure that they disclose all that kind of information so that these products are not opaque.”
Understand what you are buying
While this will go a long way to helping with decision-making, investors must still appreciate the risks.
“All of this information is intended to help the investor to make an educated choice, but it is not intended as protection from loss,” Naicker says. “You need to be fully aware of the type of risk and investment you have gone into.”
Because hedge funds use leverage and gearing, gains and losses can be magnified. This is why it’s vital to scrutinise how funds are being managed, and how they generate their returns.
“You want a manager who has been around for some time and with a proven record so that you can see the statistics,” says Winckler. “South African managers are in general more conservative than overseas, but you still have to understand what you are buying.”
In this regard, understanding the level of gearing that is employed is the first indicator of the risk level of the fund. Secondly, investors should take into account the sizes of the individual positions that the manager is taking.
“In this industry it’s very important that you don’t take very big position sizes,” Winckler argues. “Generally a holding of 8% of the fund is a very big on the long book, and a position of 3% would be big on the short book. You want to see that managers are managing these risks within the portfolio.”
On the whole, however, the local industry is characterised by strategies that try to lower risk, rather than enhance it. They are true ‘hedge funds’ in the sense that they hedge positions to ensure uncorrelated returns, rather than trying to maximise returns at high risk.
“There have been a few big smash-ups overseas, but in South Africa the ones that have been around and have a good track record are real quality,” Winckler says. “One of the big factors in South Africa is that this is a small industry and your reputation is everything. If you mess up, you don’t get that back. Also, almost all fund managers here have most of their wealth invested in their funds. So we are also looking after our own money.”