South African hedge funds conservatively positioned

Low gearing, strict oversight and the performance track record of local funds are reassuring for investors

South African hedge funds are conservatively positioned by international standards, with gearing levels far lower than their global counterparts.

That’s according to Robert Foster, chairman of the Alternative Investment Management Association South Africa (AIMA SA) and chief operating officer at Alpha Asset Management, who said that South African hedge funds are characterised by lower levels of cash borrowing, instead using short selling to adjust portfolio exposure.

Leverage, sometimes subject to incorrect interpretation, is the sum of all the exposures in a fund, whether short exposures obtained via short selling, long exposures obtained by borrowing cash to increase investment sizes, or exposures obtained through using derivatives.

“Hedge funds borrow as part of their investment approach. They borrow scrip to facilitate short selling, but some also borrow additional cash from banks or prime brokers to invest larger amounts in their positions than what would have been possible using underlying capital only. This practice is referred to as gearing, which turns out to be not as widely used in South Africa where hedge fund managers prefer a more conservative approach, reducing market risk by using short selling,” said Foster.

South African hedge funds have, over the last two years, also become increasingly focused on more liquid, exchange listed instruments, to significantly improve the liquidity profile of their portfolios.

On regulation, Foster added that local hedge fund managers are regulated by the Financial Services Board (FSB) under the Financial Advisers and Intermediary Services Act (FAIS). FAIS governs all registered investment managers and financial advisers but holds hedge fund managers accountable to a higher standard of fit and proper requirements, which has led to improved operational processes.

He noted that hedge funds follow numerous investment strategies including equity long/short, equity market neutral and fixed interest arbitrage.

“What makes them such an interesting option is that these strategies have different risk and return drivers compared with conventional investment buy and hold (long only) strategies that can lose capital when markets fall. Some hedge funds are designed to protect capital under volatile market conditions and have been successful in doing so, as last year has proven.

“In rising markets, South African hedge funds have on average managed to capture a large proportion of equity performance. That said, they tend to focus more on downside protection than on outperforming equities in strong markets - the idea being to offer investors a smoother return profile given high levels of equity volatility.”

Some detractors allege that while hedge funds deliver in terms of their mandate, they misrepresent the risks involved.

“The fact is that, in addition to regulatory control, hedge funds are subject to a high degree of oversight over their operational and portfolio risks. Most (90%) outsource their fund administration, ensuring the independent valuation of portfolio holdings, while investors in local hedge funds enjoy unparalleled levels of reporting and transparency, either directly from the fund manager’s service providers or via a third party risk manager that monitors mandate compliance and risk exposures on behalf of the investors,” said Foster.