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The bridesmaid of the local investment industry

Hedge funds struggle to gain traction.

On April 1, 2015, hedge funds in South Africa became recognised as collective investment schemes. This means they are now regulated in the same way as unit trusts.

This was a significant achievement for the industry, as South Africa became the first country in the world to put in place comprehensive regulation for hedge funds. Many people expected that this would lead to a new wave of growth for these products, as they would now be accessible to a much wider investor base, and would offer the same safeguards as unit trusts.

However, quite the opposite happened. The amount of money in hedge funds has actually declined in the past three years.

“It hasn’t been as positive as many suspected,” says Neil Verster, portfolio manager in charge of hedge funds at Novare Investments. “I think that is because it has coincided with fairly poor performance, broadly.”

The equity long-short story

At the time that hedge funds had the best opportunity to grow their market and gain wider acceptance, managers ran into a sustained patch of underperformance. Or, more accurately, the largest and most well-known part of the industry did.

Equity long-short portfolios had performed extremely well between 2008 and 2015, delivering on average around 11.5% a year. However, they suffered weak returns in 2016, 2017 and 2018.

Source: HedgeNews Africa, Novare Investments

Perhaps even more concerning, however, was that they broadly failed to offer investors the thing that they most want out of hedge funds – returns that are uncorrelated to the JSE. In a weak market, equity long-short funds did not meaningfully differentiate themselves from general equity unit trusts. This led to many large investors pulling money out of hedge funds, since they felt they were not getting any extra value for the fees they were being charged.

Read: The hedge fund issue isn’t just about returns

This reaction to the poor performance of equity long-short portfolios may perhaps have overshadowed the fact that other strategies continued to perform quite well. Fixed income hedge funds in particular have done well in the last few years, and market-neutral funds have largely continued to deliver steady, positive returns.

The wider story

“Around 60% of local hedge funds are long-short strategies, so when those funds struggled, it felt like the entire hedge fund industry was struggling,” says Glenn Silverman, acting chief investment officer at Novare Investments. “But that wasn’t necessarily the case.”

Nevertheless, this had a dampening effect on interest in local hedge funds generally.

“The biggest disadvantage to the new regulation of hedge funds was that the industry got publicity at a time when it was doing particularly poorly relative to historic returns,” Novare’s Verster argues.

Growth in hedge funds has also been constrained by the fact that even though they are now collective investment schemes themselves, other collective investment schemes, particularly unit trusts, cannot invest in them.

“There is a blanket prohibition on any unit trust having any exposure to hedge funds,” explains Jean Pierre Verster of Fairtree Capital. “Yet pension funds, which have to comply with Regulation 28, are allowed up to 10% exposure to hedge funds. This is the part of the investment landscape that needs the most investor protection, and it is allowed 10% exposure, but unit trusts that should have fewer restrictions cannot have any.”

According to the Financial Sector Conduct Authority (FSCA), this is a policy set by National Treasury. At the time it was being considered it was decided that because collective investment schemes in securities (unit trusts and exchange-traded funds) could not gear their portfolios, it would not be appropriate to allow them to invest in hedge funds, which can.

However, if unit trusts could use hedge funds, this would open up a significant opportunity since these are the vehicles used by most South African investors. Most people would probably feel uncomfortable investing directly in hedge funds themselves, but would be happy if their balanced fund manager decided it was appropriate to have some exposure.

“Those discussions are taking place,” Silverman says. “If it would be allowed, that would be a significant positive to the industry.”

The differentiator

To be relevant, however, hedge funds have to offer something compellingly different. Why should investors use these products if they are already getting diversification from balanced funds that they have been using for years?

Read: Is there a cheaper alternative to hedge funds?

The one advantage that hedge funds have is that they aren’t reliant on any asset class going up. Even in a balanced fund, if equities and bonds drop in both South Africa and internationally, just being diversified between them isn’t going to offer investors any protection. However, being able to short securities and therefore benefit when prices go down means that hedge funds can mitigate losses in this kind of scenario.

“In an event where both equities and bonds are down, what is the downside protection that you have in a multi-asset fund?” says Novare’s Verster. “In that kind of event you need an uncorrelated strategy that is not going to perform in the way that those asset classes do.”

This is the story that hedge funds need to tell. The difficulty is that it’s a hard sell in a market dominated by discussions about who has the highest return and who is outperforming whom. It is, however, their true competitive advantage.

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I am struggling to feel sorry for this part of the industry for one simple reason – fees. I think they have failed to come up with a fee structure that prices the skills they do have effectively for investors. There has been too many cases of hedge funds failing to give investors sustainable returns, whilst the asset manager ends up pocketing a fortune in the process. How much skill is there actually in this industry? How much are you willing to pay finding out? And finally, how does one recoup fees from them when they fail? If they can answer that, they might have a future.

Couldn’t agree more. I don’t see, as it relates to Equity Long/Short funds, why anyone would pay 3-4% per annum over the cycle for returns below equity but admittedly with around half the volatility. No one should pay that much for reduced volatility no matter how skilled the manager. The trade-off, in terms of lower return volatility for the exorbitant fees involved, is madness and no sane person should accept it. Why then does the hedge fund industry refuse to budge?

The problem is that the industry sold themselves incorrectly. One cannot and hence should not talk about volatility of hedge funds. This is not a appropriate measure of risk because by definition they do not follow a normalised distribution. Blame the hedge funds themselves and their sales people for selling good returns at low volatility, it is meaningless and they know it. I do however believe hedge funds have a part to play as a true diversifier to traditional asset classes. Just don’t trust the smouse out there,they are who destroyed the hedge fund industry.

Come on people, one cannot talk about volatility of hedge funds. They are not normally distributed, so volatility is meaningless. This is the problem with this industry, the smouse of the funds are clueless and the principals of the funds know this, but let them sell the low vol bull@#R&. Hedge funds have a place in diversifying a portfolio, but stop talking about volatility! You are paying for an uncorrelated asset class, NOT for low vol Or high returns. Investors need to be educated.

gflash what are you on about. It is not only normally distributed variables that have volatility. Even the Cauchy distribution has a variance (it is undefined though).

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