Hedge Funds In South Africa
By Mark Gilogley
Company: Peregrine Pacific Dunes Fixed Interest Hedge Fund

 

he dictionary defines “hedge” as to guard against the risk of loss and “fund” as a reserve of money set aside for a certain purpose.

Traditionally Alfred Winslow Jones of the US is known as the inventor of hedge funds in the late 1940s. “Hedge fund” as a concept has become difficult to define and often leads to industry stakeholders using characteristics to explain them. As an investment approach flexibility allows for investment strategies to take on both long position(s) in anticipation of an upward moving market and short position(s) in anticipation of downward trends, chase ‘absolute positive returns’ as a differentiated measurement of success, utilise borrowed money to leverage/increase investment exposure per strategic intent and incorporate derivatives and other non-securities investments as instruments for increased returns.

Hedge funds to date have neither been statutorily nor legally defined. The Managed Funds Association in the US broadly defines a hedge fund as ‘any pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public’. The premise fundamentally outlines the fact that hedge funds are known to purposefully operate outside the ambit of investment regulations and has given much rise to the debate of why pension funds and institutional investors are reluctant to invest in the current form.

AIMA (Alternative Investment Management Association) estimates that South Africa has in excess of 80 operating hedge funds with an approximate value of over nine and a half billion rand of assets invested. Factors contributing towards awareness and interest by the investing public and authorities at large are attributed to the unusually high growth rates of the product as an investment vehicle, high rates of return, limited control by investment regulatory bodies, undefined risks and the low levels of knowledge about the complexities of both the products and services. Flexibility, speed and access as an unregulated investment have however been ascribed as keys to the success and benefits of such investment vehicles.

South African hedge funds tend to focus on Long/Short Equity strategies with the second most favoured style being Fixed Interest opportunities. Industry observers attribute such trends to regulatory limitations, exchange control and the need for increased innovative financial instruments i.e. derivatives. Local participants are said to be competitively disadvantaged at the hands of international participants due to restrictions on liquidity and diversity.

The main drawback for the industry not being regulated, however, is that stakeholders are not permitted to market such products to the general public. Lags in decision making by the FSB (Financial Services Board) could be attributed to the authorities looking to larger markets with longer track records such as the US or Europe to lead the way in regulating the alternative investments industry.

Capacity constraints continue to concern leading stakeholders as the example of the Long Term Capital Management (LTCM) fund continues to weigh heavy on the minds of investors and regulators in that the world’s brightest and largest fund failed to overcome the inherent potential of systemic risk in 1998. As a lesson however, many stakeholders have taken to limit and manage risk exposure whereby it is believed by observers that excessive returns will begin to even out or become more reasonable as increased capital allocations diminish the competitive advantage of early stage participants. Peregrine incorporates a range of models to include fixed interest opportunities and the growing trend towards macro models for opportunity in spreading risk and capturing the upside in efficient diversification models.

A primary factor in the debate between traditional fund management and hedge fund management is that hedge funds are said to derive a competitive advantage from being small. Speed and flexibility enable the manager to exploit situations that larger more cumbersome funds often find difficult to copy. Investing by hedge funds (as a characteristic of closed funds) can take place without the risk of being noticed, which is often a drawback for larger funds relative to capital absorption in terms of the size of the investments.

The argument for ‘smaller equals better’ is furthered by the fundamentals that economies of scale can negate the benefits of specific events through changes in frequency and capacity that lead to the phenomenon of investment bubbles i.e. too much money chasing too few opportunities. Contenders argue that such concerns are averse to the creation of ‘market efficiency’ e.g. strategies using derivatives and short selling can be used by the more ‘sophisticated’ investor to hedge out inefficiencies.
The point being that hedge fund ‘returns’ according to a London based research firm, Crossborder, are cyclical in nature and a factor of both investment capital flows and the relative strategies employed at the time.

Critics argue that the regulatory ‘blessing’ of the industry will result in extensive growth, especially due to institutional interest. The effect is sure to place additional strain on current capacity as ‘growth models’ are seen to be adding to the complications and nervousness of envisaged diminishing returns and will, in all probability, lead to the growth in non-traditional strategies and investment fields.

For the investor that is keen but has little understanding or time to review each fund and the associated complexities, there is the increasingly popular fund of hedge fund (FOHF) option. The approach provides the investor with a service of sophistication wherein the strategy reduces the typical onerous capital requirements, due diligence needed to identify a suitable hedge fund ‘partner’ and complication that strategies making up the industry today may not be the same as in the past and are likely to be different in the future. Advantages to FOHF styles include the likes of diversification of cost and capital through economies of scale, closer access to the industry and closed funds, access to specialised services, due diligence analysis, risk management, portfolio management, strategy selection, reporting and performance analysis.

Concern, however, emanates from an increased layer of costs, exposure to other investors cash flows and less control over transparency, decision-making, preferred strategies and performance.

Projecting the South African trend
Degrees of sophistication and transparency are set to become increasingly important wherein the investor (customer) will need to attain a level of satisfaction in terms of understanding the decision making process and ability to scrutinise results as a partner in being fully aware of the risk premium associated with his/her returns.

The benefits of economies of scale as a factor of competitive forces is sure to encourage increased integration and institutionalisation of alternative investments into traditional money management styles and result in the investment class becoming an optional extra upon regulation of the industry. Retail investors to align with the trend on the basis of attaining opportunities associated with diversification at more affordable costs at trusted institutions that are perceived as having the skills and knowledge to manage investments returns. A smaller separate class of partnerships of the more sophisticated/wealthier investor types may however continue on the basis of speculative, riskier and/or innovative opportunities as an inherent trait.

The middle ground for the retail investment trend is sure to be in the advancement of Fund of Hedge Fund (FOHF) styles wherein ‘smaller equals better’ asset management styles would be contracted by larger institutional managers to retain both benefits of efficient diversification and sophistication as a measure in deterring diminishing limitations as mentioned.

Supply as a determinant of industry stakeholders themselves will evolve to capture the interest of the investors for a more secure and lucrative investment returns. We envisage innovative supply i.e. passive management styles to evolve on the back of a more developed and competitive environment if trends continue to correlate that of developed financial sectors.

By developing prime brokerage businesses to incorporate administrative functions as determined to be a global trend, prime brokers would have a financial interest in developing a core competence as administrators in facilitating the needs of both regulators and a self regulating environment i.e. to be competitively advantaged by way of meeting the sectors operational requirements in transparency to include factors such as public disclosure, reporting frequency, sophisticated technological systems and capabilities and customised reporting.

The prime broker to comply with the regulatory body’s requirements wherein additional services in terms of offering the competitive operational advantage would be encouraged as a precept to developing the sector’s competitive edge.

Sources and Bibliography
AIMA South Africa., Sep (2004) ‘Hedge Fund Booklet”
Gilogley, M., Jan (2005) MBA dissertation ‘An analysis of hedge funds as influenced by the economic, operational and regulatory environments within the current South African investment climate’
Needham, C., Sep (2005). The Sunday Times ‘Limit your risk in heady markets’
International custody and Fund Administration. Aug (2005) ‘Time for growth, hedge fund review’