Hedge funds: proceed with care

Last week the Financial Services Board published conditions under which retirement funds will be able to invest in hedge funds.

This follows last year’s relaxation in prudential investment regulations (regulation 28 of the Pension Funds Act), allowing for more investments in alternative investments, such as hedge funds.

The regulations on the use of hedge funds, which seek to reduce the potential losses for retirement funds, are now up for comment (see “Tough criteria for retirement fund trustees”, below).

Until last year, retirement funds were not allowed to invest in hedge funds.

Retirement funds and collective investment schemes have always been allowed to use derivatives but in a very limited way, namely, to protect themselves from downside risk. In simple terms, they can use derivatives, in effect, to buy insurance against losses.

In other words, retirement funds have always be able to “hedge” their assets against adverse investment markets.

How this is done is to take a position that enables them to sell shares at a predetermined price if the value of those shares starts to drop. In other words, they have been able to use “put” but not “call” options to protect themselves against losses.

According to Investopedia.com, a put option contract gives the owner a right, but not an obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares at a fixed date at a pre-determined price.

The problems occur with call options, because derivative traders use them to try to make money, but few people know the actual risks involved.

And a simple truth is that for every hedge fund manager betting one way, there is another investment manager betting the other way. Seemingly, this a zero-sum game, but it is not, because there are costs. The hedge fund manager who wins takes 20 percent of the profits as a general rule – money that is paid by you and me. And the loser takes a fee as well.

A prime example is the trade in the distressed debt of the Greek government. If the Greeks default, there are going to be some very sad-faced investors and fewer hedge funds. So over the long term, the only people likely to score are the hedge fund managers.

An important feature of the amendments to regulation 28 is that the “see-through” principle must apply to retirement fund investments if, for example, your retirement fund uses a multi-manager to select investments provided by different asset managers.

In terms of regulation 28, a retirement fund may invest no more than 15 percent of its portfolio in a company that is worth R20 billion or more.

Say asset manager A is a passive manager chosen to manage a core portfolio, while asset manager B is selected to provide actively managed satellite portfolios. Both managers could hold shares of company X, with the total holding for the fund exceeding the limit.

To ensure that this situation does not occur, retirement fund trustees and their consultants must be able to “see through” the investments, to ensure that they are compliant with regulation 28 at all times.

There is an overall limit of 10 percent of retirement fund assets in hedge funds. An investment in a single hedge fund is restricted to 2.5 percent, but the limit is higher (five percent of retirement fund assets for each entity) if the investment is through a fund of funds.

What is disturbing is that the see-through principle does not apply to hedge funds; they have been exempted. In other words, investors and their advisers may not have a clue what is going on.

The problem is that including hedge funds in regulation 28 has given these funds an air of respectability. Product floggers and, even worse, some retirement fund consultants, are running around trying to convince retirement fund trustees to sign up. Some, I have been told, are sweetening the misleading information by offering incentives such as trips on luxury yachts in the Mediterranean.

It is fine if an individual investor wants to invest in a hedge fund despite the opaqueness of the industry, but this is definitely not okay when it comes to retirement fund money. No retirement fund trustee should allow any fund assets to be invested in something that he or she does not thoroughly understand, which includes understanding the investment strategies, the underlying assets and the risks involved.

And do not be taken in by the often-repeated false claim that hedge funds are regulated; they are not. Even when the draft conditions for investments in hedge funds become law, it is not an impediment for hedge funds; it merely sets requirements for retirement funds wanting to invest in hedge funds.

Retirement fund trustees need to proceed with great care. There is a reason why hedge funds are often referred to as fudge funds!

Tough criteria for retirement fund trustees

Retirement fund trustees who want to invest money in hedge funds are going to have to jump through a lot of hoops before they allocate the savings of their fund members to the expensive clutches of hedge fund managers.

First of all they are going to have to ensure that the correct ownership and protection structures are in place to ensure that they do not lose money because investments are in some crooked scheme.

They also cannot invest your savings where there is what is called gearing (borrowing money to invest in an attempt to multiply profits but often resulting in losses being maximised). This applies to both the use of derivatives as well as hedge funds.

Your trustees and their appointed agents then have to make sure that what the hedge fund managers claim to be assets are actually there, and that they, the hedge fund managers, are not taking liberties with the way in which those “assets” are valued.

Before investing in a hedge fund, retirement fund trustees are required to consider a list of 13 things.

The list is onerous, ranging from understanding a hedge fund’s “investment strategy and objectives, investment and borrowing powers, restrictions and associated risks (including types and sources of leverage)” through to “details of any deficit positions of the short seller, uncovered positions, leverage used and side agreements”.

If you are puzzled about those two conditions it is merely indicative of how complex hedge funds can be and the need for trustees to be very sure before stepping into these dangerous waters.

At a Financial Services Board/National Treasury road show on regulation this week there was a complaint that the conditions placed on trustees for investments on alternative investments such as hedge funds and structured products are so onerous it would be almost impossible to invest in them – so trustees, be warned.

How trustworthy are big banks that take big risks with your savings?

There is a simple rule of investing: if you do not understand it, do not invest in it. One area of investing where there is much confusion is the derivatives market. Yet some financial services companies and retirement fund consultants are aggressively trying to convince individuals and fund trustees that derivatives are good for them or their funds.

Derivatives, because they are used widely and employ a wide range of strategies, are both good and evil. A problem is that the naive use of derivatives results in the unanticipated and unwanted.

In simple terms, a derivative is not an actual asset but something derived from an actual asset.

In my view, what mainly drives the providers of derivatives is the potential for the asset manager to make high profits, and not how retirement fund members or individual investors can benefit. Yes, derivatives can be used advantageously.

Derivatives mostly involve buying and selling something you do not own. The risks start to multiply when gearing is used, as it often is. Gearing is, effectively, borrowing money to invest to make (or, potentially, to lose) more money.

Last month, one of the world’s biggest banks, JP Morgan, declared that its risk management unit had lost US$2 billion in derivatives trading – yet another bank to make significant losses going back to Barings Bank, which was forced to close in 1995 because a rogue derivatives trader, Nick Leeson, lost £827 million.

If one of the more respected banks in the world can take a US$2-billion pounding because of derivatives trading, what faith can we have that other banks and asset managers will get it right?

Many derivative products, such as guaranteed index-linked structured products and hedge funds, are sold to people and institutions that have little idea of the real risks to which they are exposed – and the product floggers take advantage of this lack of knowledge, imparting flimsy information relying on sins of omission to make a sale.

A major component of the derivatives market is the hedge fund market, which, to me, should often be more appropriately described as the vulture market. Hedge funds often use derivatives to look for “market inefficiencies” to make a profit. This means you will often find hedge fund managers hanging around where there are debt troubles, such as Greece. Their presence will often exacerbate the bad situation, because they try to call and influence the future.

In the meltdown that followed the 2008 subprime crisis, half the world’s hedge funds disappeared, and the funds that remained did very little to protect the savings of investors.

The hedge fund industry, which makes extensive use of smoke and mirrors, is especially skilled at burying its mistakes by only publishing the performance figures of the funds that survive.

But even when the failures are excluded, the average performance of hedge funds is quite pedestrian.

Weavering guilty of ‘breach of duty towards investors’

Magnus Peterson, the boss of collapsed British hedge fund business Weavering Capital, has been found guilty of fraud and breach of duty of care towards investors in a civil case at London’s High Court.

Mrs Justice Proudman ruled that Peterson, manager of the Weavering Macro Fixed Income fund, had deceived clients with a strategy that could not cope with the vagaries of markets at the height of the global credit crisis.

Three other directors at the fund firm were found guilty of negligently permitting fraud to happen.

“I do not accept Mr Peterson’s assertions that the investors understood his strategy very well. He cannot show any document in which he explained it,” the judge wrote in her judgment.

The liquidators of the collapsed hedge fund business, who launched the case, intend to claim damages of at least $450 million, according to the judgment. Robert Anderson QC, representing the liquidators, alleged Peterson misled investors by concealing investments in more than $600 million of interest rate swap agreements. – Reuters