Hedge funds 101

Home/Hedge funds 101

By George Herman, Citadel Director and Chief Investment Officer

Increasing use is being made of hedge funds in South Africa, but they remain largely misunderstood by the average investor.

Hedge funds have been perceived as elitist investments or only for high net worth individuals. This is a pity, as hedge funds can offer investors excellent returns with generally lower risk. They are essentially funds which aim to generate returns that are independent of the direction of the underlying market.  Their returns should thus be uncorrelated to the bond or equity market so that they provide your overall portfolio with a hedge during unfavourable periods for that particular market.

Hedge funds can adopt a variety of investment strategies, depending on their specific nature and the asset classes they take exposure in

Positions can be taken in the physical (equity, bond or currency) or via a derivative position. Hedge funds gain their exposure predominantly via equities, bonds, futures, contract for differences (CFDs), options on futures and swaps. A fund would typically take a position in an asset in which they have a high level of conviction and expect to perform well. They would then take the opposite position in a similar asset by shorting an asset which they believe will reduce in value or would battle to generate a positive return. This combination then leaves the fund with very little nett exposure to the direction of the underlying asset class, but merely with the relative performance of the two assets. This is the ultimate expression of the core skill of a fund manager: security selection.

Hedge funds can form a very useful part of an investment portfolio

Firstly, they provide returns which are uncorrelated to both the equity and the bond markets, so by adding hedge funds to an otherwise well-diversified portfolio, it improves the overall risk-return ratio of the portfolio. And secondly, hedge funds should experience lower volatility and smaller drawdowns than pure equity or bond portfolios which makes them ideal vehicles for long term wealth preservation.

As with most investments, hedge funds do carry risk

Some are exposed to market risk and this will vary depending on the strategy and category of hedge fund. Market neutral funds have very little directional market exposure whereas macro hedge funds may have large, concentrated bets on certain global outcomes.  This is by far the most important issue when analysing hedge funds as their ability to generate returns is inexorably linked to the amount of market risk they take.

Hedge funds face credit risk on two major fronts: they may own fixed income securities which have differing degrees of credit exposure; and they implement their positions predominantly using derivative instruments. If these instruments are not listed, the fund will have over-the-counter credit exposure to the derivative contract counterparties.

Lastly, there is key-man risk. Many hedge funds revolve around the expertise of one or more key individuals. Their presence and commitment is essential to the long term success of a fund.

In South Africa, the hedge fund industry has benefited from tighter regulation

New hedge fund regulation came into effect during 2016 which has changed the perception of them as carrying a high degree of regulatory risk. It is important to note that hedge funds actually have LESS market risk and lower volatility than traditional long-only funds. The perception that hedge funds have higher risk comes from their sophistication and often secretive operations. None of these need to be feared as all hedge fund activity is under regulated scrutiny either by regulators or the exchanges via which they transact.

South Africa is also one of the leading domiciles in the world when it comes to hedge fund regulation. The South African financial markets are more concentrated and liquidity is less than in most global markets though. This does constrain our hedge funds in terms of size, risk budget and strategy diversification.

When looking for a hedge fund manager, look for several skills

Good hedge fund managers require a combination of unique skills. Some of those would be:

  • Independent thinking. Common, well known trades only get you into a stampede where liquidity disappears when the herd becomes fearful.
  • A methodical, disciplined trader as opposed to an emotional ‘noise’ trader.
  • Somebody who has shorted regularly before. Currency, bond and derivative trading typically provides such experience. Analysts that become hedge fund managers seldom have the aptitude and experience to dispassionately approach any position.
  • Good understanding of and respect for RISK.

Hedge funds are designed to take advantage of certain identifiable market opportunities and can enhance a portfolio’s returns while also lowering the risk. They are certainly worth consideration as an investment vehicle but, as with all investments, it pays to do your research before you place your money in them.

*George Herman is a Chartered Alternative Investment Analyst (CAIA)