Introducing your clients to hedge fund thinking
Financial and investment advisers who are looking for a differentiator in the competitive high equity, multi-asset fund universe will be intrigued by the unique ‘long of it’ and ‘short of it’ investment methodology explored in today’s newsletter. The topic emerges from the somewhat unusual application of a hedge fund mindset in a long-only fund management context, as presented at a recent ‘Inside the mindset of a hedge fund manager’ webinar.
Exceptional investment returns
Rushil Jaga, Executive: Partnership Asset Management at PPS Investments opened the conversation by singling out this unique approach as one of the reason for the long-term success of the PPS Managed Fund. The fund has ranked in the first quartile of the multi-asset, high equity Collective Investment Schemes (CIS) category since its inception. “Our role as a business is to identify asset managers who not only have specific investment expertise, but also align to our purpose as a business; by partnering with them we are able to deliver exceptional investment returns,” Jaga said, explaining the rationale for selecting 36ONE to manage the fund.
Tumi Loate, an investment analyst at 36ONE Asset Management and Co-Portfolio Manager of the fund, was on hand to talk attendees through the lessons learned from the overlap of hedge fund and long-only investing strategies gained over 19 years. Her presentation kicked off with a quick refresher on hedge funds versus traditional unit trusts. Both are investment vehicles; but they differ in terms of investment strategy, risk tolerance and use of leverage. “A hedge fund can employ a bi-directional investment strategy; it tries to outperform when the markets are going up or the markets are going down [with the aim of] delivering absolute returns,” Loate said, before commenting on some of the important tools available to hedge fund managers.
Short-selling know-how in a long-only fund
Hedge fund managers can choose from the same asset classes available to traditional fund managers including bonds, cash, commodities and equities. However, hedge fund managers have access to trading and risk management techniques that are not available to traditional long-only managers. They can employ a technique known as short selling and use financial derivatives such as futures or options to ‘hedge’ against volatility. “Short selling is being able to profit when a share price is going down in value, allowing the portfolio to benefit during periods of negative market movement,” Loate said. Derivatives add layers of protection for similar price swings.
The investment gurus across the FAnews reader base will probably be wondering why hedge fund basics are fouling up a traditional long-only discussion. “We think of our hedge fund investment process as one that permeates across the entire business and into the long-only space,” Loate explained. The result is a dual process that identifies the qualitative and quantitative aspects of good businesses that an asset manager wants to include in the portfolio while simultaneously raising ‘red flags’ for companies that face uncertain futures. According to Loate, the latter are businesses that the fund will avoid: “the essence of strategy is [that it considers] what not to do in your portfolio”.
There is no better test of an investment strategy than assessing the long-term returns it generates. In this case, the PPS Managed Fund stands out for delivering exceptional returns to investors, outperforming both its CPI plus five benchmark and dominating the Association for Savings and Investment South Africa (ASISA) multi-asset high equity category over multiple years. “You are being modest; you have actually outperformed by 4% per annum in a category which is arguably the most competitive in South Africa,” chipped in Jaga, who was leading the question and answer type narrative. He then pressed the portfolio manager for the ‘secret sauce’ in the market outperformance recipe.
Three factors for investing success
The portfolio manager singled out three factors for successful long-only fund management. Active, dynamic asset allocation cracked first mention. Put differently, the successful fund must be able to identify and invest in the best, high conviction ideas on offer in the markets with a continuous focus on the right mix of asset classes and sectors in the broader equity market. “Our asset allocation is dynamic and has been genuinely active over the last four or five years,” she said. Case in point, as the world entered the COVID-19 pandemic, the fund had a significant down weight in terms of its equity exposure. This weighting increased significantly to take advantage of the fear-induced discounts the pandemic caused.
The second factor for success is to be style agnostic. “Some asset managers like to term themselves growth, momentum or value investors … but with market cycles, different styles can outperform at different times,” Loate said. Being style agnostic means the fund manager can select the best opportunities from the whole of the market, rather than limiting itself to a subset of companies. And finally, the third success factor, derives from the asset manager’s hedge fund mindset, being an innate ability to avoid the so-called ‘landmine’ stocks. The managers of the PPS Managed Fund have succeeded in keeping the worst performing JSE-listed stocks out of the portfolio, for years. The ‘short of it’ capabilities have helped to identify and avoid potential return shocks.
Your role as financial advisers
The discussion turned to managing client behaviours during times of market upheaval with financial advisers receiving deserved praise for preventing clients from executing costly, knee-jerk fund exits. But the role active fund managers can play in smoothing out market drawdowns was highlighted too. Loate commented that while it was impossible to avoid the 10 worst days in financial markets in a given period, it was possible to leverage ‘the short of it’ side of the hedge fund mindset to limit exposures to the worst securities. “We do stress tests and scenario analysis to see how various securities perform during adverse market conditions,” she said.
The moderator then steered the conversation to future returns in the context of global themes such as inflation, interest rates and geopolitics. A consideration of asset class correlations and portfolio diversification emerged as central strategies to position a fund for all manner of potential headwinds. The presenter summarised the South African macro environment as one of low liquidity; slow economic growth; and above trend uncertainty and volatility. “The hedge fund mindset is extremely important during these times [as it] enables us to capture the opportunity set and still deliver alpha across the fund,” Loate said. The trick is to diversify across asset classes without sacrificing returns: bonds and equities compete for a spot in the portfolio based on both return and risk protection potential.
Turning to the specifics, Jaga asked for areas of the markets that were hot and cold presently. It turns out that 36ONE was cautious about valuations on offshore markets like the US S&P, but reasonably upbeat about prospects for sectors of the local market. Commenting on South Africa, Loate said they were negative on the outlook across the telecommunications sector, but positive on banks and some retailers. “If we do not like a certain sector, we are happy to own zero and not have any exposure to it in the portfolio,” she said. Overall, the fund was overweight technology and domestic banks, with shares in the latter sector benefiting from improved loan growth and offering solid dividend yields.
Equity exposure now at full weight
At the end of May 2024, the fund was invested 34% offshore compared to 32% mid-July. The fund has increased its total exposure to equities from 68% end-May, to 75% presently … with 47% in SA equities, predominantly in the so-called rand hedge shares. “We increased BREAK equity quite a bit going into elections, mainly through SA Inc stocks such as banks and retailers; in terms of equities offshore, we are predominantly invested in US-listed companies with a global presence,” Loate explained.
Offshore bond exposure included dollar-yielding emerging market bonds; US Treasuries; and some corporate UK paper. As for SA bonds, the asset manager shifted some of its shorter duration bonds further out on the yield curve. “The majority of the portfolio’s 13% local bond exposure is in high duration government paper such as the 2035s and 2048s,” she said. As for resources, copper and gold cracked the nod with platinum on the ‘no go’ list for now. The talk concluded with two risks to keep an eye on including stretched valuations at global technology ‘darlings’ and the ever-changing geopolitical landscape.
Writer’s thoughts:
One of the underlying messages from today’s newsletter is to trust portfolio managers to navigate market peaks and troughs. Is a firm ‘trust the experts’ reminder adequate to prevent your clients from making emotional investment decisions? Please comment below, interact with us on X at @fanews_online or email us your thoughts editor@fanews.co.za.
