Looking past the hedge fund myth

Opinion piece by Paul Harrison, Head of Sales at Sanlam Multi Manager International

The bulls are out on hedge funds this year. Globally pundits expect around R1.47-trillion to be pumped into hedge funds in 2011 alone. That’ll be four times more than last year, and will bring the industry’s total value to R15.75-trillion. Clearly global investors see the benefits of using hedge funds as a part of their overall portfolio.

South Africans, however, don’t seem to have taken up this trend yet. For one, it’s not really been worth it to date. With investors until recently only able to invest 2.5 percent of their portfolio in hedge funds, the size of the contribution has hardly been worth the bother. Retail investors have also not been encouraged to take on hedge funds, with the market still unregulated. This has all played a role in perpetuating the hedge fund myth – that these instruments are risky and expensive.

In fact, hedge funds are not as risky as they have been portrayed to be, but simply an investment strategy that is not constrained by benchmarks. Their purpose is to produce positive returns, irrespective of what the markets are doing. They generally intend to smooth that ride, and are at their most valuable when markets are volatile. They allow investors more flexibility, by taking risks off the table (or putting them back on the table), depending on the investing environment. As an example, during 2008, when the JSE all share index fell 23 percent, the average local hedge fund returned 2.3 percent. The average top ten performers returned more than 32 percent in that year.

The good news is that regulators are now increasingly realising the value of using hedge funds as part of a portfolio. Earlier this year National Treasury increased the total percentage a portfolio can invest in hedge funds to 10 percent. And according to a study by Deutsche Bank earlier this year, this fits with the global perception of hedge funds. The survey found 38 percent of clients have allocated between one and 10 percent to hedge funds, and a third between 10 and 25 percent. Four out of five clients have increased the proportion of their portfolios in hedge funds in the past year – most of these by between one and five percent.

What do global investors look for in a hedge fund? The study found around three quarters want investment performance, and two thirds emphasise risk management. Lack of performance is cited as the chief reason for the failure of hedge fund businesses. Transparency also features strongly, and has become an increasing part of an investor’s investment process.

The Deutsche study highlights the reason for the popularity of hedge funds: their good performance and their lower volatility. Some 70 percent of the survey’s investors expect the HFRI Fund Weighted Composite index, the global index tracking some 2000 single hedge fund managers, to return between five and 15 percent this year. And around 70 percent have the same expectations from their own hedge fund portfolio. Investors are not as upbeat on US indices, the MSCI World index, or the MSCI Emerging Markets index.

In South Africa, hedge funds have also offered strong returns with lower risk. The Blue Ink South African Hedge Fund Composite (BIC) – the only hedge fund index locally to track the performance of the some 100 hedge funds in the country – returned more than 31 percent in the three years to end June 2011. The JSE all share index returned just over 14 percent over the same period. What’s more, the Blue Ink index’s volatility levels have been considerably lower over the three years than that offered by the ALSI (2.8 percent for the Blue Ink index, versus 20 percent for the ALSI). Institutional investors, including big corporate pension schemes, have cottoned on to this: latest statistics put the total assets managed by SA hedge fund managers to around R32-billion – from below R30-billion a year earlier.

As for the myth on expenses, a Novare Investments study found most local hedge fund managers charge a management fee of one percent, and a performance fee of 20 percent. This is competitive with the fees on offer from actively-managed unit trusts in the country.

Of course that doesn’t mean that all hedge funds – as with any investment product – will be risk-free. It’s like driving a car: if you drive it recklessly, you’re likely to crash. That’s why it’s handy to make use of a service provider, who does the heavy lifting for you. These service providers can find the best managers domestically and globally. They also take their fiduciary responsibility seriously ensuring the right governance processes are being followed.

Given the current volatile markets – rooted in inflation pressure, US debt concerns, and euro zone worries, amongst others – flexibility may prove key. Depending on your risk appetite, now may be a time to take money off the table. Alternatively, now may prove to be a good time to pick up opportunities. Either way, hedge funds allow you that freedom. It’s time South Africa looked past the myth – and followed our global peers.

As for the myth on expenses, a Novare Investments study found most local hedge fund managers charge a management fee of one percent, and a performance fee of 20 percent. This is competitive with the fees on offer from actively-managed unit trusts in the country.

Of course that doesn’t mean that all hedge funds – as with any investment product – will be risk-free. It’s like driving a car: if you drive it recklessly, you’re likely to crash. That’s why it’s handy to make use of a service provider, who does the heavy lifting for you. These service providers can find the best managers domestically and globally. They also take their fiduciary responsibility seriously ensuring the right governance processes are being followed.

Given the current volatile markets – rooted in inflation pressure, US debt concerns, and euro zone worries, amongst others – flexibility may prove key. Depending on your risk appetite, now may be a time to take money off the table. Alternatively, now may prove to be a good time to pick up opportunities. Either way, hedge funds allow you that freedom. It’s time South Africa looked past the myth – and followed our global peers.