Hedge Funds: the long and the short of it
Jean Pierre Verster, portfolio manager at Fairtree Capital.
The Steinhoff-saga in December 2017 and the release of various reports by activist short-sellers recently have put hedge funds in the spotlight, with many questions being asked about their modus operandi, intent and incentives.
How does short-selling work?
Short-selling is an activity in which a speculator attempts to make money from a falling share price, rather than the traditional way of making money from a rising share price. The speculator needs to borrow the shares from a current shareholder, and in return pays a borrowing fee. The speculator then sells the shares in the market, but has the obligation to buy it back at some point in the future and return the borrowed shares to the current shareholder. The borrowing fee earned is an attractive extra source of revenue for certain shareholders such as exchange-traded funds, pension funds and equities trading divisions of banks. Stockbrokers or securities lending specialists facilitate these scrip borrowing/lending transactions.
As an example:
A speculator with R1,000 in capital borrows 5 shares in company X from a current shareholder (lender), currently trading at R60 per share. The borrowed shares have a value of R300 (5 x R60) and the speculator will be required to pay a borrowing fee of, say, 8% per annum on the borrowed shares.
The speculator then sells the shares in the market, realising R300 (ignore costs). Now the speculator has R1,300 in capital and a R300 liability to return the shares to the lender.
If the share price rises to R80 in a year’s time and the speculator decides to buy back the shares to return them to the lender, he will have to pay R400 (5 x R80) for the shares as well as a R24 borrowing fee (8% x R300), meaning that his R1,000 capital would then be worth R876 (R1,300 minus R424) i.e. incurring a R124 loss on the transaction.
If the share price drops to R10 in a year’s time, the speculator will have to pay R50 (5 x R10) for the shares before returning them to the lender, plus the R24 borrowing fee. The speculator’s capital is now worth R1,226 (R1,300 minus R74), making a R226 profit on the short-selling transaction.
Isn’t short-selling bad and shouldn’t it be banned?
Short-selling is a legitimate activity in a free market in which supply and demand determines price. It plays an important role in maintaining equilibrium in markets, ensuring that buyers cannot overwhelm sellers and force the share price of companies up to artificial levels, sometimes called ‘cornering the market’ in a certain share. Short-sellers assist in the efficient allocation of capital towards companies which create value, and away from companies which destroy value. Successful short-selling also acts as an incentive to seek out shares which are overvalued for various reasons, profiting from the correction of that overvaluation to more appropriate prices, enhancing the confidence of market participants that price is an indication of value.
Where short-selling does become problematic, however, is in cases where a short-seller makes false and/or misleading public statements regarding a company in order to scare buyers and drive down a share price. This is referred to as a ‘short-and-distort’ strategy. Short-sellers often prefer to operate anonymously, given the personal risks that they might face if a company should decide to employ bullying and/or smear tactics to keep critics quiet. Unfortunately, this anonymity also attracts questionable characters who make reckless statements without being identified nor bearing the consequences of their actions. Most short-sellers do their work quietly, not wanting to attract too much attention. Only a handful of short-sellers are activist in nature, preferring a public and aggressive approach, which is problematic if they do turn out to be wrong.
Conversely, a strategy equally damaging but more prevalent is ‘pump-and-dump’. This is when someone makes false and/or misleading public statements regarding a company in order to dissuade sellers and drive the share price up, so that the shares held can quickly be sold at the higher price before the market becomes aware of the falsehood and the share price drops again. Both these activities fall foul of section 81 of the Financial Markets Act of 2012 and attract harsh penalties as described in section 109, including a fine of up to R50m and/or imprisonment for up to 10 years.
Most of the short-selling activity on the JSE is done by regulated hedge funds where a company whose shares are being shorted is but one of many companies constituting the short portfolio (or short book) of a hedge fund. This is done not because the hedge fund manager necessarily believes that all the companies whose shares are being shorted will drop significantly in price, but rather as a risk management tool to offset the risks taken in the portfolio of shares held in the traditional way (the long book).
How can I benefit from short-selling?
Short-selling is not an allowable activity for traditional unit trusts. The only regulated investment vehicles which are allowed to employ short-selling are hedge funds, which have been strictly regulated in terms of the Collective Investment Schemes Control Act since 1 April 2015. While hedge fund managers themselves have been regulated since 2008 in terms of the Fit and Proper requirements contained in the Financial Advisory and Intermediary Services (FAIS) Act of 2002, the fact that hedge funds (the investment vehicles) have only been regulated for about 3 years means that they are mostly still an unknown and under-researched investment option for advisors and retail clients. Hedge funds are also not yet available on major linked investment service platforms (LISPs) such as Glacier, with the monthly pricing/dealing of hedge funds contrasting with the daily pricing/dealing of traditional unit trusts and causing system issues for LISP providers.
To compound the challenges that hedge funds are facing in terms of gaining wider investor adoption and acceptance, the last 3 years have also coincided with lacklustre performance from the hedge fund industry as a whole. While some individual hedge funds have still generated reasonable returns over the last 3 years, the expectations that investors might have had regarding hedge funds were, perhaps, unrealistic. Hedge funds are not the holy grail. They will have down years. They will underperform their equity, fixed income or absolute benchmarks for discrete periods. This is so because they still invest in traditional asset classes themselves, but they do so both long and short, which might smooth and/or boost returns, but not to the extent of offering any performance guarantees. There will be hedge funds that generate above-average returns and hedge funds that deliver below-average returns. That is the nature of a competitive industry.
How do I choose which hedge fund to invest in?
While choosing a hedge fund is similar to choosing a traditional unit trust, in terms of seeking a fund managed by a hedge fund manager who follows a robust, repeatable process informed by an intelligent investment philosophy, specific emphasis should be placed on the risk management framework of the hedge fund manager. Because hedge fund managers utilise leverage and short securities, they need to take particular care in terms of the exposures they take in their funds. A lack of proper risk management can lead to significant losses, more so than in the case of traditional unit trusts, so the investor should gain comfort in the risk management processes that the hedge fund manager is subjected to. One way to assess if risk is being managed prudently is to check what the magnitude of the largest historical monthly loss was for the hedge fund, especially for tumultuous months such as December 2017, although this is by no means a watertight indication that prospective risk will be managed adeptly. Mandate limits in terms of maximum gross exposure and single security concentration are also useful measures to assess the risk management framework.
It is also important to see what the incentives of the hedge fund manager are. Is the fee structure fair? These days, most hedge funds charge a reasonable base fee of around 1% and a performance fee with a hurdle, according to the high watermark principle. This means that the hedge fund manager will only be able to charge an above-average fee if an above-average outcome is delivered. Many hedge fund managers only crystallise their performance fee annually, which allows investors to claw back performance fees for up to 12 months. While this fee structure seems fair, many large investors such as hedge fund-of-funds and pension funds are able to negotiate even better terms in return for larger investment sums.
Conclusion
It has been a difficult start in the development of the regulated hedge fund industry in South Africa, with a number of unresolved issues: adding hedge funds to LISPs, creating ASISA categories for hedge fund performance reporting, moving some hedge funds employing simple strategies to daily pricing/dealing, allowing traditional unit trusts who are Regulation 28-compliant to invest in hedge funds within the regulatory limits (currently there is a total prohibition on traditional unit trusts investing into hedge funds) and improving on the extent of education that the hedge fund industry undertakes in the broader advisory market. Hedge fund managers also need to up their game and exceed on realistic investor performance expectations, at a reasonable fee, before the industry will see the growth eagerly anticipated by participants. It does seem, however, that this ideal is within reach, even if it means that a bear market is required as a catalyst to get us there.
This week’s Fund on Friday was written by Jean Pierre Verster, Portfolio Manager of the Protea range of hedge funds at Fairtree Capital, which follow a ‘quantamental’ strategy in both domestic and global equity markets. The strategy combines fundamental qualitative company analysis with proprietary quantitative analysis techniques, which leads to both breadth and depth of analysis and the avoidance of behavioural biases.
Jean Pierre also serves as an independent non-executive director at Capital Bank, where he is chairman of the audit committee. He was part of the award-winning team at 36ONE Asset Management from 2010 to 2016 and prior to that a portfolio manager at Melville Douglas Investment Management. He commenced his career in 2005 as a financial manager in the insurance services environment and in 2006 he gained experience as an internal auditor in Standard Bank’s retail banking division.
Jean Pierre holds the CA(SA), CFA and CAIA professional designations.
