International investors flooding back into hedge funds

Tips for local investors to consider before investing

Internationally, money is flooding back into the hedge fund market with $8.3-billion of new inflows reported globally in August, as investors look to increase their exposure to equity markets, while still protecting themselves from the possibility of another market fall.

China Investment Corporation (CIC), the emerging giant’s sovereign wealth fund, recently announced that it was moving away from cash and back into hedge funds and private equity, having now invested “many times” the $500m it was reported to have invested in June.

Locally, the ability of hedge funds to offer good upside participation with low downside participation fits well with the current mindset of many retail investors. With volatility in the local equity markets expected to continue for some time, we are expecting a similar revival of interest in local hedge funds.

While hedge funds can be a crucial building block for both retail and institutional investors, there are some important points to consider when selecting a fund.

1. What is the hedge fund investing in?

It is vital to understand what a hedge fund actually does before investing in it. The starting point for any investor is to look at what type of assets the fund invests in and then to assess the strategies that are being used in order to understand the risks involved.

Hedge funds invest in a variety of assets, each with their own degree of risk, and the differing strategies employed by hedge funds have a major impact on the return expectations of an investor.

A hedge fund that trades only in equities and hedges out all the market risk by shorting shares against those which it buys would be expected to deliver stable returns with minimal drawdown.

Alternatively, a hedge fund that invests in equities that take outright long or outright short positions in companies would be expected to generate higher returns, but with an understanding that greater drawdown is possible.

2. Who is running the fund?

In South Africa, while the hedge fund industry is unregulated, the fund managers themselves must have a category 2a license from the Financial Services Board - so it is important to know exactly who is in charge of the fund. Assuming the manager does have the correct license, the next thing an investor should look for is a separation of duties.

· The fund should have an independent administrator to ensure the value being reported is the actual value of the investments and that all assets in the portfolio are valued correctly.

· The fund should have a reputable and independent auditor. In South Africa funds will generally make use of one of the big, well-known auditing firms.

· A fund should also have an independent prime broker. The independence of the broker is vital. If the broker is a related party, the hedge fund could also be earning fees from trading.

· The fund should have an independent custodian.

3. Minimise the risks

Most hedge fund managers have fairly large minimum investments of around R1 million making it difficult for private investors to access these funds, however one route to gaining exposure without making such a large investment is through a fund of hedge funds.

This has a number of advantages for private investors. They are able to get access to a diversified investment of hedge funds, which immediately reduces the risk of being exposed to one poor fund.

The fund of hedge funds also employs people to perform the required due diligence on the hedge fund managers, as well as monitor the risk and compliance of the fund. A good fund of hedge fund manager gets full transparency from the hedge fund managers so that they can monitor the risk and compliance effectively.

The fund of hedge fund manager also makes sure that the correct structures in terms of independent administrators, auditors, prime brokers, etc are in place with the hedge funds they invest in.

4. How do the performance fees work?

The standard performance fee charged by a hedge fund is 20%, although sometimes this can be lower (around 10%) for some funds. There are three important terms one should be aware of in understanding the performance fee.

“High Watermark” refers to the highest value that the portfolio has ever been valued at. No performance fees can ever be charged if the fund is not above the high watermark and the high watermark can never reset..

“Hurdle” refers to the rate of return that must be achieved before performance fees can be charged. The fund manager is then only paid performance fees on the return above the hurdle.

“Crystallization period” refers to the measurement period of the hurdle. If the crystallization period is one year then the fund manager must beat the hurdle over that year before any performance fees are paid.

5. How can I guard against the possibility of a hedge fund blow-up?

The reality is that hedge fund blow-ups do not happen as frequently as people may think however as with any investment one should guard against a worst-case scenario. The key here is due diligence, risk management and mandate compliance.

Due diligence involves understanding key points such as the structure of the fund, the background of the fund manager, and the investment strategy of the fund.

Risk management and mandate monitoring are both part of the ongoing process that should happen on any investments, not just hedge funds. Effectively one is checking that what the fund manager said he was going to do is being done and within the constraints of the investment agreement of the fund.

It is crucial when choosing to invest in a hedge fund that you do your homework. However, accessing the market through a fund of hedge funds means not only are you able to diversify your risk, but that someone else can do your homework for you.