Interest rate volatility, stricter US trading regulations boost local hedge funds in first half of 2010

A combination of a volatile interest rate environment and increased regulation imposed on US banks regarding the use of capital for proprietary trading has boosted the performance of local hedge funds during the first half of 2010.

The results of the Blue Ink All South African Hedge Fund Composite (BIC), which tracks the performance of around 100 hedge funds in South Africa, showed that local hedge funds have returned 3.54% in the year to date to June, compared to the -4.06% produced by the All Share Index (ALSI). These hedge fund returns have also been achieved at significantly lower levels of volatility than that of the ALSI.

Kevin Ewer, Portfolio Manager at Blue Ink Investments says hedge funds specializing in the fixed interest space were responsible for most of the strong performance by this asset class. “The uncertainty around the direction of interest rates and resulting volatility over the period enabled for fixed interest hedge funds to take advantage of arbitrage opportunities that presented themselves. We expect this volatility to continue during the second half of 2010, which should further boost performance from these funds.”

Ewer says that local hedge funds have also benefitted from large US banks toning down their proprietary trading desks in the wake of the global financial crisis and stricter regulations concerning the use of proprietary capital. “In the past, these banks used their vast amounts of capital for proprietary trading in the fixed interest and foreign exchange markets, quickly closing down any arbitrage opportunities in these markets.

“With these banks now looking to reduce risk levels and shore up their balance sheets, there is far more scope for local hedge funds to take advantage of any arbitrage opportunities that open up. “We have seen local hedge funds that have been running for a long time suddenly show improved returns in 2010. A lot of that can be put down to the increased arbitrage opportunities.”

*Volatility in brackets

Ewer says that comparing the returns the various asset classes over a longer time period also reveals that hedge funds have consistently outperformed equities in South Africa, while also offering much greater protection from downside risk.

The BIC shows that the three-year total return from the JSE ALSI is 0.77% with a volatility measurement of 21.45%. In comparison, the average hedge fund returned 27.72% with a volatility level of 3.56%.

Ewer says diversification remains key to a successful portfolio. “It is difficult to know when a bull market will turn bearish which is why it is so important to always maintain exposure to strategies such as hedge funds that offer a degree of protection in periods of market turbulence.”