Is there a place for hedge in your portfolio?

John Haslett, portfolio manager at Alpha Asset Management

There has been a great deal of negative press surrounding hedge funds in South Africa. A key aspect that has been overlooked is that despite a sharp selloff in the FSTE JSE All Share Index (ALSI) this year, a number of hedge funds have provided significant downside protection, reduced volatility and are positive year to date.

In early August, a prominent hedge fund allocator, condemned the SA hedge fund space and stated that they were abandoning all hedge funds. Since then the South African equity market and that particular investment house’s exchange traded fund (ETF) have fallen by close to 9% while the Hedgenews Africa Single Manager Composite is positive over the same period - indicating that sometimes you get what you pay for!

From 1900 to the end of 2016, the South African market was the best-performing market in the world, delivering an average annual return of inflation plus 7.2% according to the 2017 edition of the Credit Suisse Global Investment Returns Yearbook. This yearbook compared the returns of various asset classes over 117 years in 21 countries with a continuous investment history. This ongoing overall upward trend has understandably made many South African investors complacent.

September and October saw the market sell off sharply, giving back not only August gains but extending the year-to-date loss to 10%.

It’s therefore understandable that South African investors who became accustomed to an upward trending market would after three years of sideways movement begin to question the status quo. This has resulted in major shifts in asset allocations from aggressive and multi asset funds to income-producing, cash like products.

However, one could argue that the timing of retail investors is wrong considering the value offered by South African equities currently. History suggests that buying stocks at these low levels has yielded positive long-term returns for investors.

The South African small and mid-cap sector for instance, has not just moved sideways but suffered significant losses over the last few years, so much so that this segment appears deeply discounted. While the rest of the world has been getting more expensive, small and mid-cap South African stocks have been getting progressively cheaper. Impatience and volatility of returns can be an investor’s worst enemy, causing them to deviate from their long-term investment plans that invariably include a large allocation to risk assets like domestic equities.

Although the last three years have been tricky to navigate for all managers in South Africa, the Alpha Prime Equity Hedge QIHF (Qualified Investor Hedge Fund) has managed to outperform the market since its inception in 2006 (net of all fees) and is positive to the end of October. Even more impressive, is that this has been done with 60% less volatility, which equates to fewer negative months and smaller losses.

The net effect is that investors that made regular use of hedge funds, have not only been able to allocate a larger portion of their assets to growth investments without taking on additional risk. They have also been more likely to remain invested due to the lower volatility experienced. This will ultimately improve the probability of them achieving their investment goals.

Instead of moving away entirely from risk/growth assets to cash-like products, a more prudent option would be to include a select number of quality hedge funds that can still capture the upside in a very discounted market ,while protecting against the kind of sharp draw downs witnessed recently.

The hedge asset class includes strategies that are completely uncorrelated to equity market performance by trading commodities and fixed income, thereby offering true diversification in one’s overall portfolio.

The key is to understand what you are buying. Instead of excluding hedge funds altogether, rather engage the assistance of a professional fund of fund house that has evaluated and combined these various strategies in an effective way. This will allow you to become more familiar with the asset class and create a more diversified portfolio without sacrificing returns.