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Use of hedge funds in a Regulation 28 portfolio

Changes in legislation means stricter regulation of hedge funds in South Africa.

Changes to legislation in April 2015 have finally meant that registered, South African hedge funds will become regulated under the Collective Investment Schemes Control Act (CISCA), which is the Act that governs unit trust investments. This should mean more oversight and supervision for investors from the Financial Services Board (FSB). It will also give new and existing hedge fund investors greater tax clarity on their investments. This is because hedge funds will be taxed on the same conduit basis as all other collective investment schemes, offering investors’ far greater clarity than in the past.

This then brings hedge funds, which manage assets of more than R70 billion (as at December 2015), fully into the regulated environment.

Curiously, in the past, hedge fund managers have had to be registered as Category IIA licence holders which is the most onerous management licence issued by the FSB. In order to qualify for this licence, hedge fund managers are held to higher experience standards, require greater capital adequacy and stricter qualifications than those that are necessary for a Category II licence (the licence necessary for traditional, long only managers).

Secondly, since 2011, Regulation 28 of the Pension Funds Act has allowed retirement funds to invest up to 10% in, at that time, unregulated hedge funds. This meant that an average investor, who was contributing a monthly amount into a retirement annuity or pension fund could have been investing 10% of that amount into hedge funds.

An increase in regulation should then surely benefit investors, both retail and institutional.

A major misconception of hedge funds, at least in South Africa, is that they are high octane, high risk and high return products. Whilst there are certainly a few funds with this risk profile, the majority of hedge funds in South Africa are aptly named – they are designed to hedge, or protect investors.

Novare Investments, a leading, multi-manager was established in 2001 and has specialised in alternative investments since then, most notably in hedge funds. 2015 was the 12th year that they complied the Novare Investments South African Hedge Fund survey, which is probably the most comprehensive and far reaching work of its kind in the industry. On February 1 this year, they were the first local asset manager to launch regulated retail hedge fund products.

Eugene Visagie, head of Hedge Fund Investments at Novare believes that a well balanced portfolio could include a weighting of 10% to 20% in hedge funds in order to provide greater stability in portfolio returns since the primary objective of hedge funds is to produce returns that are uncorrelated to returns of other asset classes. This is particularly true in periods of high volatility, when hedge funds’ ability to protect capital can result in a less volatile portfolio.

This intuitive reasoning also appears to be backed by historical performance. Novare ran two, hypothetical, Regulation 28 compliant portfolios from December 1 2007 until July 31 2016. Portfolio 1 had a static weighting of 60% to the JSE Alsi Total Return index, 30% to the All Bond Index and 10% to the JSE-Listed Property Index. Portfolio 2 then had a 10% allocation to the HedgeNews Africa Long/Short Equity Index and a pro-rated allocation to the other same three indices in Portfolio 1 (54% Alsi, 27% Albi and 9% Property).

The Hedge News Africa Index is a simple mean of all the single manager long/short ZAR funds’ performance in South Africa who report their performance to Hedge News Africa. (The long/short hedge funds category is by far the largest and oldest category in South African hedge funds, with 60% of all hedge assets being managed this way in 2015 according to the Novare survey).

Over the period in question (104 months), the inclusion of the maximum allowable allocation to hedge funds had virtually no improvement on the performance. Where it did have a positive impact however was on the volatility of the overall portfolio, as the table below illustrates.

N

The higher Sharpe ratio represents a higher risk adjusted rate of return for Portfolio 2 over the period. The less volatile portfolio could also potentially mean that, for retail investors in particular, they are less likely to make rash, knee jerk changes to their portfolio in times of market stress as their portfolio is likely to suffer less than the overall markets. The increased certainly in the return stream can only be of a benefit to investors.

Another factor that should further strengthen Novare’s research is the issue of hedge fund fees. Hedge funds are widely perceived to have higher fees than traditional, long only portfolios, largely due to their use of performance fee structures. However, the Hedge News Africa Index is the only index used here that is net of all fees, both management and performance fees if applicable. The JSE, Albi and Property index are all gross of fees and even if low-cost tracker ETFs were used to achieve these returns, it would reduce those returns.

All in all, the regulation of hedge funds by the FSB and the resultant opening up of an alternative asset class to all South African investors should be seen as an improvement in the South African financial environment. In a future where local markets are likely to provide more muted and volatile returns than investors have enjoyed since 2008, another investment option for investors should be welcomed.

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Zah Mthethwa

Zah Mthethwa

Masthead Financial Planning
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