Hedge funds: your safety net for 2015

Post the global financial crisis of 2008 we witnessed a consistent decline in global equity markets’ volatility with the exception of isolated periods of increased volatility. This has also been the case for South African equity markets as represented by the South African Volatility Index (SAVI) in Graph 1. The SAVI measures the equity market’s expectation of the JSE Top 40 Index’s 3-month implied volatility. Historically there has been a negative correlation between the SAVI and the JSE Top 40 Index performance, this indicates that the more wary/uncertain investors became of equity markets, the more we experienced a sell-off in equity prices. In mid 2014 we saw the SAVI reach its all time low since the index was introduced in 2007 and then reversed and has been climbing since, indicative of increased expectations of uncertainty going forward supported by our outlook that broader macro themes causing uncertainty will not subside in the near future.

A couple of factors contributed to this reversal in investor sentiment and we believe these factors will continue to dominate investor behaviour through-out 2015:

– Investors remain wary of the global growth slowdown especially in China. This has led to a lacklustre demand for commodities. Coupled with this, the broad based, self-sustaining recovery we are witnessing in the US will continue to support a strong US Dollar and this does not paint a rosy outlook for already weak commodity prices. This will ultimately put pressure on commodity driven economies i.e. mainly emerging markets.

– Eurozone economic growth has not recovered to pre-crisis levels and now faces the threat of deflation. The currency union’s post-crisis financial reform has not been successful in kick starting its economy and its hand has now been forced to introduce an asset purchasing program to provide support to its economy. Investors will keep a close eye on how the ECB carves its way to recovery and we can expect this to cause times of uncertainty.

– We are entering a global monetary policy transitioning period and witnessing a dislocation between policy in the US and the Eurozone. The market expects the US to tighten policy during the second half of 2015 and the Eurozone now has to introduce quantitative easing to provide support to its struggling economy.

Graph 1: SAVI vs JSE Top 40 Index

We expect a volatile 2015 and recommend that investors protect their investments against a sell-off in equity markets, particularly locally. One way to protect against the drop in equity prices is to have exposure to hedge funds. To illustrate the benefits of investing in Hedge Funds in periods of increased volatility, we take a look at the beta-adjusted returns of two South African Hedge Funds and Long Only Funds in November and December 2014 when we witnessed a sharp increase in equity market volatility. Graph 2 provides a graphical illustration of the alpha return potential of Hedge Funds versus Long Only Funds over volatile periods.

Graph 2: Hedge Funds vs Long Only Funds

During periods of increased volatility, as represented by the shaded area where we saw an increase in the variation of equity market returns as represented by SWIX, Hedge Funds were able to generate positive alpha returns whilst Long Only funds destroyed alpha. Long Only managers tend to deviate in times of increased volatility which often deceives general manager selection criteria. Given the increased volatility we expect in 2015, we believe that Hedge Funds will provide investors with sufficient protection against a market sell-off without the cost of giving up any upside.

The 27four Investment team have been active in the South African hedge fund industry since the birth of the industry in the late nineties. We hold significant experience and credibility in this area of expertise and would welcome assisting you in capturing the full benefits of this investment strategy. For more information, please contact us at info@27four.com.

By Vic du Preez and Christiaan Janse van Rensburg