It’s been a difficult few years for South African investors, who had become accustomed to lucrative returns on their portfolios. Frankly, investors have not been rewarded for taking on the risk of equity or property, left perplexed by a low growth environment.

Diversification away from equity markets provides risk buffers in the form of uncorrelated investments which can outperform when equity markets do not. And that is where hedge funds come into play.

According to analysis firm RisCura, the broader South African equity market was down in 2018 by -14% with a volatility of 12%. On average, the dominant form of South African hedge fund strategy — named the long-short strategy — outperformed the markets significantly, returning marginally positive returns, though with a wide range of volatilities.

“Only looking at return numbers, without understanding volatility and gross exposure is therefore far too simplistic and results in asset allocators throwing the proverbial baby out with the bathwater,” says George Tsinonis, head of investment analytics at RisCura.

Of the multitude of hedge fund strategies used globally, many South African hedge fund managers focus on just two, namely “long-short” and “market-neutral” he says.

“Yet, even within these two strategies many different tactics are used to achieve many different objectives, so it is practically impossible to make accurate comparisons.”

Take, for example, the following sample of long-short funds:

It shows how different the range of returns can be over a given period as well as the ranges of volatility and gross exposure, says Tsinonis.

“Hedge fund managers using a long-short strategy can invest in a broad range of assets. The use of shorting and a flexible asset allocation process which means the return profiles of the funds can vary significantly, hence the need for additional information like volatility and gross exposure, particularly over time,” he says.

Actually, hedge funds make-up can differ significantly. Hedge funds can also provide access to certain “niche “ asset classes like commodities which can benefit a broader diversified portfolio, rather than serving as a standalone investment.

The difficulty in comparing the local offering, coupled with lacklustre returns and high fees, have not earned local managers the greatest of raps over recent years, says Herman Sandrock, head of distribution at Fairtree Asset Management.

In 2007, amid growing concern about the perceived lack of transparency in the South African hedge fund industry, regulations were published, which established certain fit and proper requirements for hedge fund managers, introduced the procedures which hedge fund managers are required to follow in order to obtain authorisation to act as such and the creation of a code of conduct for hedge fund managers.

It took much industry much effort and great collaboration with authorities to get the regulated infrastructure in place, says Sandrock. The result has been worthwhile as regulation has provided additional comfort to clients, greater fee and mandate clarity and has made it easier for clients to compare funds in a consistent manner.

In 2019, the Association for Savings and Investment South Africa (Asisa) released the Hedge Funds Investment Management fee standard on 1 March, and on 19 September it released the Asisa Hedge Fund Classification Standard.

According to Asisa the classification of South African regulated collective investment scheme retail and qualified investor hedge fund portfolios provides a framework within which hedge fund portfolios with comparable investment objectives and investment universes are grouped together.

“ It is a key tool for investors and their advisers in that it provides useful information during the consideration of investment choices,” ASISA states. 

Sandrock says in recent past industry players have complained that the complexity and high fees structures did not warrant an investment but now that traditional asset classes have delivered poorer risk-adjusted returns, hedge funds’ role as diversification tool can be better appreciated. 

One of the benefits of hedge funds is its ability to go long and short. “To generate a return from shares going up and down” he says. Where investing in the JSE All-share index will follow just that with significant exposure to large stocks e.g. Naspers and Prosus hedge fund can generate returns from rising and falling shares prices.

Hedge funds can provide diversification through their asymmetrical return profiles, their ability to hedge out market risk, plus their use of leverage to enhance returns.

In conclusion, there is definitely a place for hedge funds in portfolios, especially to genuinely diversify returns from mainstream asset classes. BM