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The hedge fund issue isn’t just about returns

It’s also about diversification.

Sygnia’s decision last week to close all of its hedge funds has raised important questions about this industry. What are hedge funds supposed to do, and how should investors judge whether they are delivering?

In particular, many investors have been asking how you should measure their performance against traditional unit trusts. Since balanced funds are also designed to manage risk while delivering returns close to the stock market, are they directly comparable?

While this may seem logical, Werner Opperman from 27four Investment Managers says that contrasting these strategies against each other may not be entirely the right approach.

“My argument here is a similar argument to what I would say in the active versus passive debate,” he explains. “It’s not either-or. Hedge funds form part of the universe of tools you can choose from. Depending on your objectives, you can decide to use them or not.”

He points out that the value of hedge funds is not always evident in their pure performance numbers. What makes them valuable is that hedge funds offer risk adjusted returns that are higher than most other solutions.

Risk vs return

As the chart below indicates, for the five years to the end of June this year, the major hedge fund categories all outperformed cash (STeFI) and the bond market (ALBI). Their returns were however below equities (SWIX All Share).

Source: 27four Investment Managers

Roughly speaking, this is where one would expect these strategies to fall. Importantly, using their standard deviation, or volatility, as a measure of risk, the hedge funds also produced higher returns for each unit of risk they took.

While it is important to note that conflating volatility and risk has its problems, strategies that produce returns at lower volatility can be extremely valuable. When investors need to create smoother return profiles they have a big role to play.

Hedge funds can also offer meaningful diversification benefits.

“Hedge funds offer access to different strategies and hence different sources of risk premia,” says Opperman. “This in turn enhances the diversification characteristics of your portfolio. You end up with a more robust portfolio that is not reliant on pure long-only equity return. Just like you would diversify across asset classes one should be diversified across strategies in each asset class.”

Delivering diversification

That is the theory. The problem over the last few years, however, is that equity long-short hedge funds have failed to deliver this diversification. It is not just that they have performed poorly, but that they did not offer anything meaningfully different from traditional strategies.

Selwyn Pillay, chief investment officer of Sanlam Multi Manager International, says that he largely moved away from using equity long-short hedge funds because what they were offering was too similar to what he could get from traditional equity funds.

“The alpha signatures that I was buying from an equity long-short hedge fund were too similar to the alpha signatures I was buying from long-only equity managers,” Pillay explains. “I would rather spend my hedge fund allocation on alpha signatures that I can’t access in the long-only space, and those have predominantly been in fixed income, commodities and the multi-strategy funds.”

It is this more than their pure returns that hedge fund managers may need to address.

“Some hedge funds drastically underperformed because they stopped looking for new ideas and diversification strategies,” Opperman suggests.

However, there are signs that this may be changing. Although the performance of hedge funds over the last three years has been disappointing, it has improved noticeably over the course of this year.

Returns to 30 June 2018
Hedge News Africa Fixed Income Index Hedge News Africa Long/Short Equity Index Hedge News Africa Market Neutral & Quantitative Strategies Index Hedge News Africa Single-Manager Multi-Strategies Index SWIX All Share Index STeFI ALBI
5.63% 0.97% 1.95% 2.32% -4.82% 3.54% 3.97%

Source: 27four Investment Managers

While equities have delivered a negative return, hedge fund strategies across the board have managed to produce positive numbers.

Even within this universe, however, it is clear that there is a wide range. This illustrates another vital point that the debate on hedge funds has raised – that these products are not homogenous.

The nuances

The more unconstrained nature of hedge funds means there is an extremely wide range of strategies they can follow. This is the other major benefit to investors – that it is possible to find risk return profiles in the hedge fund space that simply aren’t available anywhere else.

“For example, there are hedge fund strategies that can give you equity-like volatility, and equity-like returns, but invest exclusively in the fixed income space,” says Pillay. “You get zero correlation to equities, but a similar pay-off profile. This also means that you could get draw-downs of 20%. So that isn’t a capital protection-type fund, and it isn’t meant for an investor looking for that type of product.”

As hedge funds are still new to most South Africans, these kinds of nuances need to become better understood. Investors still have to become comfortable with the range of different strategies available and what they offer.

“Investors need to be more cautious and understand what they are investing in,” says Pillay. “That’s not necessarily the mechanics of the funds, but at least their risk profile.”

This will allow them to understand what kind of outcomes they should expect.

“There is also an obligation on the hedge fund industry to make this more explicit,” Pillay says. “They need to show investors how much they could potentially lose in a bad environment, and how much they could get in return. They must show the asymmetry in the investment product. That is where the retail investor needs to get more comfortable.”

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Good article Patrick. One thing I have had a problem with for a long time is people comparing hedge funds to long only funds in terms of volatility. Hedge fund strategies by their very nature do not (and should not) deliver returns that are normally distributed, hence volatility cannot be used as a measure of risk. One needs to look at more complicated risk measures and that is the problem – it is difficult to explain this to the average investor. In my opinion hedge funds have been sold very badly here in SA and probably worldwide. It is all about diversification, it is not about massive out-performance of other asset classes. Although the new retail hedge funds are limited in their strategies, the good thing is that hopefully there will be far more regulation in how these funds are sold so that the average investor is properly informed. Hedge funds have an important part to play in a well constructed portfolio.

Good article. All too often articles in the financial press are of a dare I say “populist” hue. Active management (be it long only or hedged) is the antichrist. Active managers sole purpose in life is to rip of clients. Same goes for investment bankers and chartered accountants. Round them all up and burn them at the stake.

What Magda is doing is not all that dissimilar from Julius Malema’s strategy. Oversimplify an issue and come out with a sollution that is likely to appeal to the majority, cynically so as she very well knows that the debate is more nuanced.

On another note if I optically draw a regression line it would seem that equity long/short has been a better risk adjusted bet than long only, ALBI has been a disaster where fixed income hedge funds have given you a 1% more return for 7% less risk. Market neutral hedge funds however has been dissapointing – not outperforming risk free cash.

On my LISP platform I do not have the ability to access hedge fund strategies, is that the norm?

For now it is the norm. Hedge funds are however starting to be included on LISP platforms. More should become available over the course of the next 18 months.

I know hedge funds that has delivered over 20% p.a. for the last 6 years. Sometimes 40% and only once dipped. With the correct focus and strategy they are 3 times worth the risk than tracker funds.

Yes, hedge funds provide valuable ‘fee diversification’! You get to diversify generally reasonable fees with outrageously high hedge fund fees. What I don’t understand is why don’t the hedge fund managers just price their product more reasonably? Is that too much to ask? Charging something like 4 times long-only fees for equity long/short is a form of abuse.

In my head hedges are not an asset class, they are an instrument to use in conjunction with your other assets. So, if you have had a great run in long equity technology stocks, you buy some protection. Whether through selling covered calls or buying puts or buying a leveraged inverse ETF, you can stay long in your now highly / overly priced favorite tech stocks, but get downside protection.

The classical good hedge is party A is a Mexican holiday resort worried about too much rain and occupancy, party B is a mexican corn farmer worried about insufficient rain. Whatever the rain, if they were counter-parties in hedge on mexico rainfall, both get some insurance from betting on the opposite sides.

There is no space for billions in fees in that relationship between the resort and the farmer. Neither is there a place for a pension fund to take ANY side in that hedge, unless it invests in resorts or farmers.

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