27four Investment Managers
22nd May 2015
Getting used to the idea of retail hedge funds
From April 1 this year the way that local hedge funds are regulated has changed. Under the Collective Investment Schemes Control Act (CISCA), hedge funds can now be offered to retail investors as collective investment schemes as long as they meet certain criteria.
Investors still have to wait for the first Retail Investor Funds to be approved and launched, but this is likely to happen before the end of this year.
However, although hedge funds will be recognised as collective investment schemes in the same way as unit trusts or exchange-traded funds, they won’t work in exactly the same way. Investors will have to get used to the idea of three major differences.
1. Larger initial investments
Retail hedge funds are likely to require investors to put down a minimum lump sum of at least R50 000, and perhaps as much as R100 000. While there are some unit trusts that have similarly high thresholds for entry, most accept much lower amounts.
Part of the reason for this difference is the complexity, and expense of processing transactions when it comes to hedge funds. To make it cost effective, they need to work in much larger numbers.
“There is a huge amount of administration around hedge funds, and only a few firms specialise in it,” says Albrecht Gantz, head of investment analytics at Riscura. “The systems are vastly different to those used for unit trusts, because they need to facilitate different kinds of accounting.”
A second consideration may be that regulators, and hedge funds themselves, are cautious about who they want to attract into these products.
“By setting a high initial investment amount they restrict who exactly will be able to invest into the hedge fund space,” says Claire Rentzke, head of manager research at 27four Investment Managers. “They are trying to ensure that people think long and hard about whether hedge funds are suitable, and if they are appropriate for their end goals. They don’t want every man on the street flocking into hedge funds just because they are available.”
2. Longer redemption periods
Most unit trusts will pay you out within 48 hours if you request a withdrawal. With hedge funds, however, the industry standard is 30 days.
Investors will therefore have to be comfortable with the idea that these funds are slightly less liquid. That doesn’t mean that they carry enormous liquidity risk, it is rather a reflection of how they implement their strategies.
“Although hedge funds typically hold large amounts of cash, they utilise derivative markets and the contracts they have in place often mean that the money isn’t always readily available because of collateral requirements,” Rentzke explains. “Positions can’t necessarily be exited quickly, especially if you have short positions because it can take time to unwind those. It’s not something that can be done overnight.”
In a nutshell, the nature of the instruments used in hedge funds restricts how quickly they can free up cash. A unit trust that is long on Anglo American can sell a huge chunk of that holding in a matter of minutes, but when derivatives come into play, this takes more time.
“The structure of the positioning in hedge funds is a bit more complex,” says Rentzke. “You can’t just sell half of your derivative exposure. You have to unwind the contract and put a new contact in place and change its nominal value. It just becomes a bit more technical, so you want to protect other investors and not just make liquidity available to exiting investors at any price.”
The longer redemption periods also won’t mean that hedge funds are cagey about what they are invested in, or that investors won’t know the underlying holdings. In fact, hedge funds are likely to be less opaque than unit trusts in this regard.
“We have daily transparency on hedge funds, and a day or two after month end we have a look through on all their holdings,” explains Gantz. “With unit trusts, if we want to do reports, we usually have to wait two months to get transparency at a holdings level.”
3. Performance fees
While performance fees are not uncommon with unit trusts, they are standard with hedge funds. The most recent Novare Investments Hedge Fund Survey shows that most local hedge fund managers charge a 1% management fee and 20% of out-performance of a benchmark.
This is lower than the ‘2-and-20′ formula that is prevalent in most international markets, but the contentious thing for many investors will be the benchmark used. The Novare Survey shows that more than 10% of South African hedge fund managers charge performance fees from zero, while the majority, 76.8%, charge on any returns above cash.
One of the things the hedge fund industry will have to face up to is that these are likely to be seen as very poor, if not unacceptable, benchmarks. If all investors wanted was a cash return, they would put their money in the bank. Hedge funds therefore need to accept that investors will expect cash-plus or CPI-plus returns, and will only want to be charged performance fees if they get it.
“It is a very contentious issue and I think when entering the retail space a lot of managers are going to have to think about how they charge fees,” Rentzke says. “We may well see a shake-up. It is expensive to run a hedge fund, but they need to be consider what investors will be willing to pay.”
Many people might think it is more appropriate to benchmark hedge funds against an equity index, particularly if they are running long-short equity strategies, which are the most common locally. However, the difficulty with that is that hedge funds are not designed to keep up with equity market returns in a bull market.
Hedging strategies are designed to promote downside protection to mitigate against negative market movements. As such they will naturally under-perform when markets are strong.
“A hedge fund is not going to give 100% of the upside,” Gantz says. “If a manager can build a product that gives 65% upside and only 35% of the downside when the market falls, then over time that is a good product and worth paying for.”
Investors will therefore have to get used to the idea of scrutinising fees more carefully. They will have to consider what they are prepared to pay for when it comes to hedge funds, and look for those products that meet their requirements.
Patrick Cairns | 22 May 2015