Hedge Fund Selection: A Multi-Management Perspective

In early March 2023, the Financial Sector Conduct Authority (FSCA) released a draft notice of amendment to Board Notice 90 for comment.

The notice may allow CIS Managers to include up to 10% in a combination of retail investor hedge funds in Unit Trust portfolios managed in accordance with Regulation 28.

This new regulation means that retirement portfolios may soon be able to access this asset class, prompting broader questions about the role hedge funds can play in a diversified portfolio.

There is a common misperception that hedge funds are mostly risky investments, but the SA hedge fund industry offers products that cater to various risk profiles across different strategies. It is therefore critical to assess what goal you are wanting to achieve with your hedge fund allocation - such as diversification, volatility reduction, return enhancement or some combination - to identify which hedge fund strategies might be more suitable.

The broad hedge fund categories offered by single managers in the SA industry are Equity Long Short, Market Neutral and Fixed Income. But what can they add to an SA portfolio?

Figure 1 below compares the median risk and return for each hedge fund category with SA Equity and SA Nominal Bonds on an annualised basis over the last 10 years.

Figure 1: Annualised returns relative to volatility

Source: Morningstar Direct & Hedge News Africa, 1 February 2013 to 31 January 2023

Equity Long Short funds in general, generate most of their returns from long or short exposure to equity or using equity-related derivatives (think Put Options, Call Options, Futures). Importantly, they have the tools to benefit from both falling and rising markets which may deliver better returns but is also a source of diversification. However, given that returns are driven by equity opportunities - they can decline alongside the equity market. Figure 1 shows the median Long Short Fund was able to deliver better returns than the equity market at roughly half the volatility over the last 10 years.

Market Neutral (MN) Hedge Funds generate exposure from the equity market but tend to hedge out much of the market risk using derivatives or by pair trading. Pair trading is a relative value strategy where you are long a share and short related shares (think two SA Banks for example) this allows you to benefit from the outperformance of Bank A relative to Bank B while hedging out the sector risk. The risk profile of funds can differ widely – some can be thought of as highly conservative investments while others might aim to outperform equities with lower risk. In Figure 1 we can see that the median MN Fund has delivered reasonable absolute returns with very little volatility of just over 2%.

Fixed Income Hedge Funds can generate returns from nominal and inflation-linked bonds both long and short or make use of interest rate derivatives like Forward Rate Agreements (FRAs), Swaps and Options. These managers may take advantage of mispricing or use models to estimate the paths of macro variables such as inflation, growth and interest rates to express investment views. The management of these funds is complex, but the risk profiles can range from conservative funds aiming to deliver high levels of consistency in return (as can be seen from the median fund’s 10-year return profile) to more aggressive funds that at times can be as volatile as the equity market. Importantly this category offers meaningful diversification to equity markets but can be exposed to other types of risk.

The key takeaway is that SA hedge funds are not homogenous, even within the same category, the strategies used, and the associated return profile can differ widely. This can be seen in Table 1 which shows summary statistics for each hedge fund category discussed above using 3-year annualised returns. The range of return outcomes for the SA Long Short Equity category is stark at 31.8% between the top and bottom performer. Though often driven by outliers, the range is also considerable at 22% for Market Neutral & Quantitative Strategies. Whereas Fixed Income Hedge Funds delivered a relatively narrower range of outcomes at 7.2% over the period.

Table 1: Hedge Fund Category Descriptive Statistics

Source: PPS & Hedge News Africa, 1 Feb 2020 to 31 January 2023

Given this dispersion, a deeper understanding is crucial in determining whether the firm has the necessary skills to implement the strategy successfully. We acknowledge the importance of a good track record while at the same time note that investment conditions do change over time and what was achievable in the past may not be repeatable in future.

As individuals we can be easily seduced by the promise of significant performance. Given this tendency and the complexity of hedge funds, a rigorous in-depth research process is essential to mitigate bias,

avoid knee-jerk reactions and ensure that there are no big surprises. The PPS manager research process is both quantitative and qualitative and focuses on factors such as organisational stability, experience, incentives and the investment philosophy, process and risk management.

We consider the universe of SA hedge funds and over the last few years have identified several quality investment offerings. These funds serve different roles and while there is overlap, in general, they either aim to enhance returns, diversify systematic risk, or introduce a greater level of consistency in investment outcomes. Therefore, as the regulatory climate evolves, investors should stay abreast of this unique asset class.