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Hedging Investments


  • Hedge funds
  • Stephen Cranston | 07 June 2012
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    For most investors, hedge funds are the preserve of a secretive minority. They have been described as a remuneration policy masquerading as an investment. Instead of just taking a modest flat fee of, say 0,5%, they can take a 2% flat fee and 20% of the upside.

    The term hedge fund was coined by Carol Loomis of Fortune magazine in 1966 in a cover story on the success of the original long/short fund run by AW Jones. Her definition was: "A hedge fund is a private investment vehicle where the manager has a significant personal stake in the fund and enjoys high levels of flexibility to employ a broad spectrum of strategies involving derivatives, short selling and leverage in order to enhance returns and better manage risk."

    The promise of solid returns in an environment of well-managed risk has helped hedge funds and their close cousins, managed futures funds, to gather US$2trillion internationally.

    In SA they have not enjoyed the same success. The unit trust industry recently grew to R1trillion in assets. But in the year to June 2011 the SA hedge fund industry's assets actually fell from R32,1bn to R31,4bn. A popular unit trust such as the Allan Gray Balanced Fund alone has almost R53bn under management.

    Stephen Brierley, head of Old Mutual's Symmetry fund of hedge funds, says that since the global financial crisis there has been a strong focus on old-fashioned equity investment from his clients, as shares have appeared to offer good value. "There is not strong demand to include hedge funds in a balanced portfolio."

    Investors who might otherwise flock to hedge funds in SA have a wide choice of stable and absolute return unit trusts, which promise a low-risk option to investors without the perceived risks of selling shares short and without the gearing of hedge funds.

    Private equity, which competes with hedge funds in the alternative asset space, has gathered more than three times as many assets. Perhaps private equity funds earn money the old-fashioned way, by making businesses more profitable and not through financial alchemy.

    Hedge funds are often seen as funds run by people with a fantastic grasp of theory but little sense of the real world. Just look at Long-Term Capital Management in the US, which collapsed even though it was run by several Nobel laureates. Or else they play havoc with the world economy, such as George Soros's Quantum fund which "broke the Bank of England" after selling short the pound sterling aggressively in 1992.

    But most funds are in fact a lot more dependable and far less glamorous. Blue Ink Investments, a fund of hedge funds in the Sanlam stable, says hedge funds have five characteristics:

    They aim to provide absolute returns. "We beat the index but still lost you money" doesn't cut it in hedge funds.

    Hedge funds take long and short positions: this is probably the defining characteristic of this asset class (see box on page 35). It allows them to make money in both rising and declining markets.

    They make use of leverage. The gross amount invested is often substantially higher than the total invested by clients.

    Usually, the manager has "skin in the game" as a large proportion of his own capital is invested in the fund.

    The high performance fee, Blue Ink argues, aligns the interest of the manager with that of the investor.

    Hedge fund managers certainly do far more than unit trust managers to contain losses. In the five years to the end of April 2012, the worst loss on the all share index was 13,2%; the worst for the hedge fund index was 2,7%.

    Whether hedge funds add much value to institutional investors - which have a 25-year plus investment horizon - is less clear. Pension funds can tolerate volatility, so by investing in hedge funds they are paying insurance they do not need to pay.

    Symmetry's Brierley says the market-neutral funds, which aim to sterilise systemic market risk (or Beta) have not always been true to label. "It is disappointing to see how much market performance has affected these funds."

    But he says that the performance of some fixed interest funds has been impressive, with the AcuityOne hedge fund giving a 24,2% return over 12 months and Atlantic Point 21,2%.

    Over the past five years, which includes the 2008 market crash during the global financial crisis, the hedge fund index is up 8,9% compared with 7,1% for the all share index. And in 2011, hedge funds outperformed all the other major asset classes with a 9,1% return, compared with 2,5% from the JSE, 8,8% from bonds and 5,7% from cash.

    There is no cheap or effective way to buy an investment which replicates the index. Investors such as pension fund trustees can try their luck investing with single hedge funds. But the spread of returns is even larger than it is with unit trusts. The most successful fund over five years was Signal SA Systematic, with a 33,2% annualised return - though it was ineptly marketed as it has only R8m under management. Five years ago investors might well have chosen the Interneuron Freestyle portfolio, as its fund manager Willi Jonker had worked at Allan Gray, Norwich and other successful fund managers. But it would have been a bad decision as the fund has returned a pitiful 1%/year over five years.

    Hedge funds go back to 1996 in SA but it was only in 2006 that industry assets went above R10bn.

    There are several trends which could lead to hedge funds moving into the mainstream over the next two years. The most significant is the amendment to regulation 28 of the Pension Funds Act. This determines where retirement funds may invest. Previously, there was no direct reference to hedge funds in the regulation.

    It formed part of the "other" category of 2,5% for everything outside equities, cash, bonds, property and Krugerrands.

    But under the amendment, pension funds may invest up to 10% of their assets into hedge funds. In theory this could increase the size of the industry tenfold to R300bn.

    Blue Ink points out that the Financial Services Board's (FSB) definition of hedge funds looks at them from the point of view of what unit trusts are not.

    It defines a hedge fund as "a portfolio which uses any strategy or takes any position which could result in the portfolio incurring losses greater than its aggregate market value at any point in time. Its strategies include but are not limited to (a) leverage or (b) net short positions."

    Hedge funds are unlikely to be available to the R200/month debit order investor. Overseas they are usually only sold to qualifying investors, with investable assets of at least $1m.

    There are still discussions between the FSB and the Association for Savings & Investment SA (Asisa) to determine exactly what hedge funds will be available to retail investors. But it is expected that the minimum investment into full-strength hedge funds will be R100000.00

    Retail investors might get access to the "hedge fund lite" products allowed by the European legislation known as UCITS. Michael Denenga, an attorney specialising in the financial sector, says that it remains to be seen how much of the UCITS principles will be incorporated into local regulations. The FSB has been vacillating about this version of UCITS for more than five years, and a fourth version is imminent.

    Denenga says that a future development should be to run a regional or global fund from SA - single country funds are very much the exception, and a legacy of the exchange control environment in SA. "It is not a given, though, that these funds will be domiciled in SA; Mauritius has a more attractive regulatory regime."

    But Denenga is impressed with the way the SA hedge funds have regulated themselves. There are a number of checks and balances as almost all funds use independent custodians, as well as prime brokers. The disclosure to clients is extensive by global standards.

    No major frauds have come to light in SA hedge funds; the only complete failure was Evercrest, which held a short position in Sanlam when the share was doing well - and it still returned some cash to shareholders.

    SA hedge funds are generally quite low-risk and conservative. But Byron Green, chief investment officer of Caveo, a hedge fund of funds manager, says that even though there have been a lot more inquiries from pension funds, there has not been a tsunami of assets coming into the sector. "Institutions need to decide where to disinvest from before they move assets into hedge funds."

    Simon Peile, head of the Sygnia fund of hedge funds operation, says many of the early adopters of hedge funds have found that they are over 10% in the asset class, when local and international hedge funds are included, and they have to rebalance downwards.

    But over the next two years it is likely that SA hedge fund assets will grow substantially. Robert Foster, who represents the industry in negotiations with the authorities, says it was not worth spending time getting acquainted with hedge funds, as a 2,5% exposure would not be material.

    He says it will be hard for there to be an explosion in the number of hedge funds as, in order to get a category 2A licence, managers need to have three years of managing money in hedge funds and cannot simply slide in from a long-only shop. The traditional asset management industry provides the majority of hedge fund managers. The long established Peregrine was started by Dave Fraser and Clive Nates, formerly of Liberty Asset Management. Patrice Moyal at Visio - probably the most respected hedge fund manager in SA - is also ex-Liberty.

    RMB Asset Management (now Momentum) has been the training ground for hedge fund stars such as Royce Long and Richard Simpson of Obsidian, Malungelo Zilimbola at Mazi Capital and Rayhaan Joosub of Sentio Capital.

    It is not hard to see the attractions of leaving a large bureaucratic shop, with compliance officers telling money managers what to do. Hedge funds still have to go through the motions of compliance to keep the FSB happy, but they get a lot more freedom.

    "I used to spend a lot of time in RMB in meetings which had nothing to do with investment," says Long. "Now I don't have to spend time going to report-backs on unit trust sales in Mangaung."

    There is also a lot more investment freedom, which they argue will benefit the client. Peile says that hedge fund managers can play with a full set of golf clubs, while long-only managers, because they cannot short shares or buy into other asset classes, are playing with a driver and a putter only.

    Another favourite analogy is that long-only managers are expected to bat or play tennis with one hand tied behind their back. But independent hedge fund managers do not have the security blanket of a safe corporate job.

    And because hedge fund managers co-invest in their funds, the prospect of losing money is much more real than in unit trusts.

    Greater freedom and responsibility, with the prospect of greater rewards has also attracted staff from bank proprietary trading desks.

    It is a similar activity to running a hedge fund, as they have a brief to make money trading fixed income, equities, derivatives and currencies.

    Investors would be understandably nervous to give money to prop desk traders after the $2bn losses made by JPMorgan's team. But KADD Capital, which runs the successful Validus fixed income fund, is made up of mostly former prop traders. Acumen Capital is run by the former leaders of the interest rate trading team at Absa.

    But Peile says it is not a given that a good prop trader will become a good hedge fund manager. "At a bank, a trader has access to important proprietary information; at a hedge fund he is on his own."

    Most hedge funds, and even asset consultants, will provide a single entry point to a basket of six to 10 funds.

    The return profiles are much more predictable than for single funds, though they will not shoot the lights out.

    In the Alexander Forbes fund of hedge funds manager watch over the past five years, annualised returns vary from 4,5% to 8,5% over five years, net of all fees.

    This might seem pedestrian but it was achieved with much less volatility than equities, which produced similar returns over the same period.

    Funds of hedge funds can monitor hedge funds in which they are invested on a full-time basis. Caveo, a joint venture between Peregrine and Investment Solutions, monitors 80 funds. Green says the industry is becoming increasingly corporate, with increased compliance. He says a number of funds in which Caveo invests can be considered core tenants, such as the 36One hedge fund, managed by Cy Jacobs and the Abax Constellation fund.

    Says Peile: "Ten years ago hedge funds were often one man and no dog. Now there are usually at least three or four people in the professional staff."

    Peile says that out of the large investment houses, Coronation has been particularly successful with its Multistrategy, Presidio and Granite funds, which all have strong franchises as quality funds.

    He says that Investec has not been as successful - its flagship fixed interest fund had a poor 2011. Sanlam has also battled, with staff losses in its Gen-X unit, while Old Mutual closed funds run by Peter Brooke and by its Electus equity team.

    Hedge funds certainly need a high-energy, entrepreneurial culture - Coronation still seems to have this, even in middle age.

    David Bacher, CEO of Brait Solutions, argues that hedge funds proved their maturity in 2011 when their returns were comfortably ahead of the 2,5% from the all share index. Out of the 19 long/short equity funds, 10 had a return of more than 10%.

    "Hedge funds have been able to preserve capital and, depending on how the proposition has been sold, they should not have disappointed clients."

    It is unlikely, though, that if assets grow too much, hedge funds will be able to sustain their past performance (such as it has been). There are a limited number of shares that can be shorted - though a lot more scope for fixed income funds to grow. As often happens the early adopters have got the best deal.

    But hedge funds are certainly a diversifier for pension funds. They can still show positive returns when markets are tanking.

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