SA hedge funds deliver on their mandate

By deploying short selling strategies to reduce market risk, ahead of more speculative options like borrowing to raise exposures, South African hedge funds have been able to deliver on their mandate to investors.

Speaking from Cape Town today, Robert Foster, Chairman of the Alternative Investment Management Association South Africa (AIMA SA) and chief operating officer at Alpha Asset Management noted that, while not unique to hedge funds, short selling is one of the techniques employed on a daily basis by alternative investment managers in their quest to deliver returns at lower volatility.

“Hedge funds strive to preserve capital even when markets fall, and they have been successful in employing a range of strategies to actively adjust the exposure of portfolios to market risk.

“By nature, hedge funds look to invest by either selling assets and profiting from a fall in price, or buying assets and profiting from a rise in price. Besides short selling, they may make use of derivatives and leverage, which is a potential by-product of the process rather than the key driver of returns,” said Foster.

Contrary to some perceptions that hedge funds were risky, poor performing investments, Thomas Schlebusch, AIMA SA board member and chief investment officer at Blue Ink Investments said the track record of the industry was indicative of the ability of hedge funds to protect against volatile prices and potential capital losses.

Over the period from August 2001 to February 2009, hedge funds delivered annual returns of 18.19% with volatility of 4.69%. The all share index returned 14.84% a year with volatility of 19.48%. The all bond index returned an annualised 10.83% with volatility of 7.6%.

The majority of South African hedge funds follow either equity long/short or equity market neutral strategies, which means that the underlying instruments are often the same as long only investors in the equity market - making it incorrect to assume that all hedge fund returns will always be “uncorrelated” to those of the equity market.

However, the additional tools that hedge fund managers have at their disposal to actively adjust their portfolios’ market exposure means they are less restricted than most of their long only counterparts who need to follow a relative benchmark (for example, index tracking funds) or invest within certain predetermined asset class limits (for example, balanced funds). It is the wider range of strategies that brings different return and risk drivers to a portfolio, as well as diversification benefits.

Short selling reduces market risk by introducing a different return driver, for instance profiting from a stock specific view and ignoring the general direction of the market. Whereas a long only portfolio is mostly impacted by the direction of the market, and is therefore exposed to market risk, a hedge fund can position itself to be neutral to market movements.

The mechanism enables managers to profit from a fall in an instrument’s price, compared with a long-only investment that profits if the price rises. Stock is borrowed via a contract from a willing participant and sold in the open market. This is termed selling the share “short”. The contracts have specific terms at the end of which the scrip needs to be returned to the lender and the manager requires the price to fall, before buying the shares back in the market at a lower price, to make a profit.

Ruth Forssman, AIMA SA board member from Peregrine Prime, a local equity-specialist prime broker, explained that a pair trade is a classic example of how hedge funds capitalise on a perceived mispricing in two related counters.“The ability to short the expensive share and buy the undervalued counter is a relatively lower risk investment strategy for capturing returns for investor when compared to single direction long only investing.”

Although short selling is intended to reduce market risk, the practice is not risk-free. Rising share prices may translate into losses for a hedge fund on its short positions, which can be offset by the managers’ gains in their long positions. Prudent hedge funds adopt strict risk management practices to prevent large losses.

External risk management is a key feature of the South African market as most funds have independent fund administrators and prime brokers who monitor the investment risks on a daily basis.

The South African financial industry has in place checks and balances to oversee short selling. Market participants engaging in these strategies have to abide by JSE rules, while the involvement of independent prime brokers is a source of comfort for hedge fund investors. Rules prohibiting naked short selling meant that the local market continued to operate as usual last year when certain other jurisdictions implemented naked short selling and conventional short selling restrictions in an attempt to curb volatility and stabilise markets.

Carla de Waal, AIMA SA board member and portfolio manager at Novare Investments, noted: “We’ve been insulated against certain risks compared with other countries because naked short selling, which can theoretically involve selling more shares in a company than are in issue, is not permitted. This can have a destabilising effect on markets. Instead, in SA, hedge funds actually increase market liquidity.”

Forssman also noted that gross and net exposure levels in equity centric hedge funds have altered quickly in the fast paced recovery environment, similar to many long only equity funds. During July and August when equity markets steamed ahead, hedge funds stepped up their gearing and net exposure.

“There are a number of hedge funds that have delivered double-digit returns in recent months by either maximising the scope of their bias or capitalising on classic hedged trades.As long as there is a lack of consensus as to an established trend in the market, hedge funds are in a better position to capitalise on opportunities in the medium term by deploying short selling strategies”