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The three myths of hedge funds

26 May 2015 Tatenda Chapinduka, Sanlam Investments

On 1 April 2015, National Treasury declared hedge fund investments to be collective investment schemes (CISs), and would be regulated under CISCA (Collective Investment Schemes Control Act) just like other unit trust portfolios. South Africa is the first in the world to offer these regulated hedge fund products as CISs, and this opens an exciting new chapter in the South African hedge fund industry. Now, together with the FSB’s changes to Regulation 28, which governs the way pension funds invest, it is recognised that hedge funds now have a rightful place within the pension fund space, and retirement funds can invest up to 10% into a hedge fund of funds.

A powerful diversification tool

Hedge funds provide important diversification benefits in a portfolio. A number of international academic studies have shown that the overall risk/return characteristics of a diversified portfolio improve when hedge funds are included as part of a balanced portfolio (Schneeweis, Karava, Georgiev, 2002). In addition, leaders in asset liability management, US Endowments, have consistently increased their allocation to alternatives and, in particular, hedge funds over the last ten years. They cite the predictability of returns and consistency of alpha as the main considerations.

Local research mirrors the international experience too. Domestic hedge fund returns have been impressive and their inclusion in a domestic balanced portfolio had a significant impact during the 2008/2009 global financial crisis. For example, in 2008 the equity market was down 23%, but some hedge funds were up.

Hedge funds hedge (protect) against downside risk, although some hedge funds utilise other tools of modern finance, such as short selling and derivatives to manage downside risk.

A history of consistent outperformance

Hedge funds first appeared on the South African landscape in the late 1990s, and have steadily grown to R57 billion in assets under management over this period. This growth, which has been as a result of new investor flows and investment growth, has been quite phenomenal considering that it took unit trusts 36 years to grow to R100 billion in assets under management.

Hedge funds have generated good performance over the period 2002 to 2014. For instance, the Blue Ink Long Short Aggressive Strategy Index, which tracks hedge funds with a higher equity market exposure, has outperformed the All Share Index. Overall hedge fund performance, as measured by the Blue Ink Hedge Fund Composite Index – an equally weighted Hedge Fund index – has outperformed cash and bonds, with a low correlation to these markets and at low levels of volatility.

Exhibit 1: Hedge Fund Performance (Blue Ink Long Short Aggressive Strategy Index, Jan 2002 – Dec 2014)

Why the negative bias?

The evidence is compelling. So why have less than 4% of South African pension fund assets been allocated to hedge funds?

Previously, hedge funds were not recognised under Regulation 28. However, in 2011 National Treasury and the FSB introduced changes that recognised hedge funds and alternative investments as an integral part of any diversified portfolio, and allowed allocations of up to 10% of a portfolio’s assets. However, the perception that hedge funds are ‘risky’ investments has persisted. The most cited reasons for not investing in hedge funds are that they are complex, expensive and lack transparency.

Until now, institutional investors have felt that the challenges of navigating the hedge fund world are just too daunting, despite advantages in terms of attractive returns and diversification.

Three myths dispelled

There have always been misperceptions around the hedge fund industry and these new hedge fund regulations have helped dispel some of the myths. Here are some of the misconceptions, and how the hedge fund regulations help to ease investor fears:

1) Hedge funds are more risky than other types of investments – By allowing hedge funds to be regulated under the CISCA framework, National Treasury acknowledges that hedge funds are no more risky than other investment products, and they can be made available to all investors. Hedge funds use sophisticated techniques to apply more effective risk management techniques, participate in falling markets and create a return profile which is uncorrelated to equity and bond markets.
2) Because hedge funds use leverage, there is a greater chance that I will lose more than my investment - In light of the new regulations, no investor can lose more then he/she invests into the fund. This is the concept of ‘limited liability’. Similarly, the new regulations ensure that proper risk management is instituted and risk exposure is limited.
3) Hedge funds are not transparent – To the contrary, there are stringent reporting requirements in hedge fund regulations. There are specific disclosures and reporting requirements to investors. Currently the hedge fund industry offers daily see-through to investors and we expect this to continue.

In the well-documented context of lower returns for longer, isn’t it time to think past the traditional asset classes and incorporate alternative investments into your asset allocation? We have witnessed one of the longest bull markets across both equities and bonds, and one needs to start thinking about hedging investments against a possible environment of lower returns to help maximise retirement outcomes.

If you don’t want to be penalised for taking on too much ‘risk’, the solution may be to diversify into assets such as hedge funds which offer relatively uncorrelated returns in comparison to traditional asset classes like equity, bonds and cash. Hedge funds are designed to reduce market volatility for investors by applying specialist strategies and should be considered as one of the building blocks of a well-diversified investment portfolio.

 

 

Quick Polls

QUESTION

South Africa’s Financial Sector Conduct Authority (FSCA) has the power to raise revenues by issuing administrative penalties and fines against non-compliant financial services providers, with this money flowing back to the Treasury… Does this, in your view, create a regulatory / government conflict of interest?

ANSWER

Absolutely, as conflicted as it gets
Maybe, I’m on the fence on this
No, the FSCA can do no wrong
The guilty must pay
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