Why invest in a hedge fund?

With local regulations changing, retail investors will soon be able to invest directly into local hedge funds. These vehicles will be recognised as collective investment schemes in the same way as unit trusts or exchange-traded funds.

However, there will be a lot of questions about whether this is a good thing. There are even some people within the financial services industry that aren’t shy about suggesting that hedge funds are just an expensive way to lose money.

The concept that many South Africans have of hedge funds is based on what they have heard about those in the US that have free reign to do just about anything. This includes making extensive use of debt and investing in illiquid fixed assets like physical property or art.

Hedge funds internationally also have a reputation for running into liquidity problems, or simply not meeting their mandates. In the 2008 market crash, many hedge funds in the US blew up completely instead of providing the protection to investors that they should have.

This fed the perception that these instruments are expensive, high risk, and highly leveraged. And while this is perhaps not entirely undeserved, the term ‘hedge fund’ can cover a wide array of quite different strategies.

The first thing that investors need to understand, therefore, is that not all hedge funds are equal. And in South Africa in particular, the way funds are managed is really quite conservative.

“There’s a big divide between the hedge fund industry in South Africa and what you see globally,” says Albrecht Gantz, head of investment analytics at Riscura. “Globally there are many different types of strategies that allow managers to utilise all sorts of instruments, but in South Africa most funds are variations of equity long-short, depending on the level of market exposure required.”

The most recent Novare Investments South African Hedge Fund Survey showed that 59.9% of assets under management in local hedge funds are in equity long-short strategies. Fixed income hedge funds hold 11.6% of industry assets, multi-strategy funds 9.3% and market neutral 7.1%.

This bears out the contention that local hedge fund managers rely predominantly on ‘vanilla’ strategies. Their products are not highly leveraged either and when push came to shove in the financial crisis actually performed quite admirably.

“In 2008 local hedge funds really did manage to fulfil their mandate and provide protection,” says Claire Rentzke, head of manager research at 27four Investment Managers. “They might not have been up, but they didn’t have those significant draw downs that the market experienced.”

It is this protection against negative market movements that really makes hedge funds attractive. They can be used to insulate a portfolio against big draw downs.

“Hedge funds certainly do protect against downside volatility because of the nature of their strategies,” says Stephen Brierly, head of hedge fund manager research at Old Mutual Multi-Managers. “That’s because they can vary their nett exposure to the market through derivatives and cash – they don’t always have to be fully invested and can use short positions to protect their portfolios on the downside.”

What this does mean, however, is that they are unlikely to give you all of the market returns on the up-side. As they are not fully exposed, hedge funds are likely to lag the market when it is going up.

However, there is a lot to be said for products that protect investors against big losses. As the below graph illustrates, the gains required to make back what you have lost start becoming exponentially larger as the size of the loss increases.

“In a bull market you might feel you are losing out in a hedge fund, but when a market correction happens, you will see the benefits,” Gantz says. “I think it might be difficult to convince retail investors that hedge funds are the best investment in a bull market, so the best thing for the industry might be a decent market correction for managers to prove themselves in the retail space, similar to what they did during the 2008 financial crisis.”

The perception that hedge funds are inherently riskier investments than long-only unit trusts, is one that perhaps will be challenged as they become more accessible. Some in the industry would certainly argue that in the current environment with equity valuations as stretched as they are, it is far riskier being in a long-only mandate than in one that offers significant protection against a pull-back.

“We’ve been through a period of very low volatility, but recently it has started increasing,” Rentzke says. “And it’s in these kind of periods that hedge funds should come into their own. They may get criticised in a rampant bull market for not keeping up, and perhaps only showing 65% or 70% of market returns, but when the market drops, that’s when hedge funds will provide protection.”

What is critical, however, is that anyone wanting to invest in a hedge fund must be sure that the product they are choosing is suitable and has a mandate that matches their requirements.

“From an industry perspective we would hate to see someone putting a whole lot of their money into a hedge fund strategy without understanding the implications of what they are doing,” says Brierly. “Because if they then get a result that they weren’t expecting, they might think that that’s a problem with the hedge fund, rather than an issue with how it was selected.”

Source: Moneyweb

Author: Patrick Cairns