Hedge funds – friend or foe?

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Elmien Wagenaar

elmienInternational popular media on hedge funds

Popular international media is rife with despairing headlines relating to hedge funds, like hedge funds haven’t delivered on their promise,[fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][1] Will hedge funds be around in 10 years?[2] and Buffet says hedge funds get unbelievable fees for bad results.[3]

Not making headlines are articles like “Hedge Fund AUM On the Rise March 10, 2016[4] that quotes the latest Credit Suisse Annual Hedge Fund Investor Survey saying that despite several years of lackluster aggregate returns, hedge fund assets under management are expected to climb 3.5% in 2016.

It quotes Robert Leonard, global head of capital services at Credit Suisse, who says that “Institutional investors remain committed to their hedge fund allocations and are optimistic for further growth in the industry during the upcoming year.” He added that “Increased interest in strategies such as equity market neutral, global macro and equity long/short trading-oriented appears to indicate that investors are anticipating another challenging environment for 2016. Key factors noted in making new allocations were net returns, pedigree of investment team and lack of correlation with other investments.”

South African legislation – new opportunity for the general public to invest in hedge funds

Many South African investors ask whether they should excitedly welcome this investment opportunity or with trepidation steer well clear? 

In South Africa many hedge funds are now regulated under the Collective Investment Schemes Act (CISCA) and available as unit trust funds to the general public.

Many South African investors ask whether they should excitedly welcome this investment opportunity or with trepidation steer well clear?

The trusted financial advisor owes his client clarity that will result in an informed investment decision.

“Average” returns and “relative” expectations

The root of much confusion lies in the fact that hedge funds don’t have a set definition or standard approach and thus any generalised media statement or investment decision around hedge funds could greatly mislead.

The Securities and Exchange Commission in the United States says the term ‘hedge fund’ first popped up in 1949, but that “it is not statutorily defined.” The Financial Services Authority in the United Kingdom admits to “no universally accepted meaning.”

The International Monetary Fund argues hedge fund-style instruments have been around 2,500 hundred years and defines them by four attributes: focus on absolute (rather than relative) returns, plus the uses of hedging, arbitrage and leverage.

Also in South Africa, the Financial Services Board under the new CISCA regulation for hedge funds will appropriately govern risk taking of these funds, but do not prescribe the strict classifications of mandates prescribed by Association for Savings & Investment South Africa for traditional assets.

The differences in hedge funds are not only conceptual. It also translates into large differences in returns which have vital implications for decision making.

It’s like asking the shop attendant how sweet the average fruit on the supermarket shelf is this week.

A Blackrock study shows that the spread between the highest and lowest returning US hedge funds are far larger than that of traditional stock and bond investments.

For the period from 2005 to 2014, the spread between the top and bottom decile hedge funds was 37.8%, compared to the only 10.1% for large cap core funds and 5.4% for U.S. government bond funds.

Locally, the Novare Hedge Fund Survey for 2015 also evidenced a differential of 48.9% for the best and worst performing funds classified under the largest hedge fund strategy.

Misleading terminology – “average” hedge fund returns

Large variations in any set of investment returns reduce the usefulness of a reference to its average (like asking the shop attendant how sweet the average fruit on the supermarket shelf is this week). Similarly, this holds true for the usefulness of average hedge fund returns when making investment decisions. Where popular media articles quote the average statistics in support of statements that hedge funds have not delivered on their promise[5] – the statistics are actually of limited use to make rational investment decisions.

For example, this statement

“In the first quarter of the year the average fund lost 0.8% after fees, according to Hedge Fund Research, an index provider. That follows a loss of 1.1% for the average fund in 2015, and a gain of just 3% in 2014. In other words, the average investor has earned a cumulative 1% since the start of 2014”

is factually correct, but can only be used to make an informed investment decision if all funds delivered more or less similar outcomes, which Blackrock’s study shows is not the case.

What is a hedge fund?

Hedge funds invest in any number of strategies regardless of the common term that attempts to box them.

These strategies include investing in asset classes such as shares, bonds, commodities or currencies.

Hedge funds are exposed to certain market risks and hedge against others.

One must ascertain on a case by case basis therefore:

a) what risks a fund hedges;
b) how it hedges against this risk; and
c) what portion it hedges.

The above is crucial to understand a fund’s performance.

What does it mean to hedge?

“Hedging” roughly means managing risk.

Typically, a money manager employs a particular hedging technique to mitigate a particular type of risk.

For instance, market risk – the risk of a decline in the overall market – can be hedged against by selling a broad collection of securities short in equal proportion to one’s long exposure.

Other types of risk often hedged against include interest rate, inflation, and large weightings in a sector, region, single company, or currency.

 

Relative return expectation

This decision may be to their detriment as their risk exposure remains largely to the direction of equity

To this point THINK.CAPITAL acknowledges that not all investors require risk reduction as their main mandated aim, but many do have a need for risk diversification.

  • Some investors with a higher tolerance for risk are reluctant to invest in hedge funds as many of these funds lag equities in an up market – the reason for this lag is that upside is sacrificed in hedge funds in favour of consistent, positive returns.
  • These investors then stay invested in equities rather than considering an investment in hedge funds. However, this decision may be to their detriment as their risk exposure remains largely to the direction of equity markets and the investment portfolios cannot gain from any decline in the share prices of equities.
  • In contrast, if the portfolio included some investment in specific hedge fund mandates that did not lag equities significantly, the portfolio could also have profited from falling share prices and improved risk diversification significantly.

Manager selection and the opportunity of dispersion

The relative importance of strategy allocation and manager selection in hedge funds is the opposite of traditional investments.

A research paper by Girish Reddy, Peter Brady and Kartik Patel [6] quotes a number of studies that have shown that for traditional asset classes, the vast majority of investment performance is driven by asset allocation decisions, and that manager selection is far less important.

For example, the decision of how much capital to allocate to domestic equity, fixed income, emerging markets, commodities, etc. is likely to have a much greater impact on the performance of a portfolio than the decision about which international equity or fixed income managers are chosen.

This insight is true because the difference in performance between asset classes tends to be much greater than the difference between managers within a particular asset class.

For example, the performance of most fund managers will not stray very far from their benchmark, so the decision to invest with any one of them is far less important than the decision of how much to invest in one asset class versus another.

Hedge Funds are unique in this regard

A key finding of their research is that the relative importance of strategy allocation and manager selection in hedge funds is the opposite of traditional investments.

With hedge fund strategies, manager selection has a greater potential impact on performance than strategy allocation.

This is primarily due to dispersion of returns between hedge fund managers pursuing the same strategy, combined with the relatively low dispersion of returns between different hedge fund strategies.

The facts presented a unique opportunity to combine hedge fund skills to provide a solution for the needs of investors – not to create a different risk profile, but to rather deliver a differentiated risk exposure as an alternative source of returns.

Friend or foe?

Run away from general statements and averages. They can only misconstrue. But ignoring the benefit of a finely selected portfolio of hedge fund strategies can be equally irresponsible.

In SA, many hedge funds managed to deliver excellent risk adjusted returns after all fees. Many added significant diversification to their traditional alternatives and resulted in strong inflation beating returns for their investors.

THINK.CAPITAL Investment Management Pty Ltd is an authorised financial services provider (FSP 46714).
Visit us online at www.thinkcapital.co.zahttp://www.thinkcapital.co.za

Email: info@thinkcapital.co.za / elmien@thinkcapital.co.za

Tel: +27 (0)83 236 4099

Physical address:

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General

Collective Investment Schemes are generally medium- to long-term investments. The value of participatory interests (units) may go down as well as up and past performance is not necessarily a guide to future performance.

The RCIS THINK Growth QI Hedge Fund is a third-party named portfolio, managed by Think Capital Investment Management Proprietary Limited (“THINK.CAPITAL”), an authorised financial services provider. RCIS retains full legal responsibility for this Portfolio as manager in terms of CISCA RealFin Collective Investment Schemes (RF) Proprietary Limited is registered and approved by the Financial Services Board as a manager of Collective Investment Schemes approved in terms of the Collective Investment Schemes Control Act and has delegated the investment management function to THINK.CAPITAL, an authorised financial services provider (FSP 46714) in terms of the FAIS Act, a category IIA financial services provider.

This document is for information purposes only and does not constitute or form part of any offer to issue or sell or any solicitation of any offer to subscribe for or purchase any particular investments. Opinions expressed in this document may be changed without notice at any time after publication. We therefore disclaim any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable directly or indirectly to the use of or reliance upon the information.

[1] The Economist, A losing bet by Buttonwood. 7 May 2016.

[2] Investopedia article by S Ross dated 10 April 2016.

[3] Bloomberg article by S Basak and N Buhayar dated 30 April 2016.

[4] Markets Media article by J D’Antona..

[5] Hedge funds haven’t delivered on their promise 10 May 2016.

[6] Are Fund of Funds Simply Multi-Strategy Managers with Extra Fees? Journal of Alternative Investments. Vol 10, no. 3 (Winter 2007)[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]