The long and the short of investing in hedge funds

South Africa’s hedge fund industry is still small, with only an estimated R30 billion in investors’ funds under management. Yet this sector can be expected to soar within the next two to three years as institutional and retail investors begin to understand exactly why this class of investment is so attractive, particularly in volatile equity markets.

There is still a great deal of mystique around hedge funds in South Africa. Many investors wrongly perceive them to be high-risk and exotic investment instruments, says Steven Liptz, co-founder and director at independent investment manager, 36ONE Asset Management.

He adds that in South Africa, as in the rest of the world, hedge funds have significantly outperformed asset classes such as unit trusts because they are designed to take advantage of both up- and downside in the equity market.

On the international front, the hedge fund industry is growing from strength to strength despite – or perhaps because of – the global economic downturn and the resulting market volatility. Earlier this year, hedge funds worldwide reached a milestone of having more than $2 trillion in capital under their control for the first time.
Liptz says that this shows both that investors have confidence in hedge funds and that hedge funds are performing well in a difficult equity market. He says that the very term ‘hedge fund’ is derived from the fact that such funds are designed to reduce the risk that investors face when they take part in equity markets.
Hedge funds, unlike unit trust funds and most other equity instruments, take positions in the stock market that should allow them to benefit when markets fall as well as when they rise. Like equity funds, most hedge funds will also invest in companies whose share prices they expect to rise.
But they also take positions in companies whose share prices they expect to fall and ‘short-sell’ them. The way that they do this is by borrowing shares from other institutional investors for a period of time and then selling them. They buy the shares back when their price falls and return them to the owner, pocketing a profit in the process.

“This approach allows hedge funds to maximise return on investment regardless of the market’s direction,” says Liptz. “Good hedge funds can manage market volatility by taking positions that will enhance investors’ capital whether markets are going up or down.”

Most South African hedge funds are managed by boutique operations like 36ONE rather than the large financial services companies or asset management firms. They offer their investment products both to high net-worth individuals and institutional funds.

Liptz says that 36ONE’s hedge fund has delivered returns of 5.7% on a six-month horizon, 18.9% on a twelve-month basis, and 19.3% per annum since inception in 2004 for the period ended August 31. This is despite turbulence in the equity market throughout 2011. Liptz cofounded the firm in 2004 with Cy Jacobs after both had worked for various large institutions for a number of years.

There will be a great deal of movement in the South African hedge fund market in the months to come that should spur growth for the industry, says Liptz. One factor that will drive growth is a provision in Regulation 28 of the Pensions Fund Act will allow pension fund managers to invest up to 10% of their assets in hedge funds. This is a massive increase from the 2.5% they were allowed to invest in the past.

As in the rest of the world, South African hedge funds are also becoming more transparent and regulated, giving investors more faith in them as investment options. Hedge fund managers need a licence from the Financial Services Board and more regulation is anticipated for the industry in the years to come.

Liptz says that the 36ONE investment philosophy combines a top-down macro-economic perspective with a bottom-up approach to picking stocks to ensure that the company is exposed to the right opportunities in the right industries and segments at the right time. It also emphasises the importance of knowing each company and its management to guide investment decisions.