This article was first published in the second quarter 2016 edition of Personal Finance magazine.
The first regulated hedge funds have been approved by the Financial Services Board (FSB) and are ready to solicit business from you, the individual investor, if you have R50 000 or more to invest.
The hedge fund regulations under the Collective Investment Schemes Control Act (Cisca) introduce greater protection for investors, but should you include these funds in your investment portfolio? If so, what information do you need to make an informed decision?
What are the requirements with which hedge funds now have to comply?
From September last year, all new hedge funds domiciled in South Africa were required to register in terms of Cisca. Existing funds have been granted a further year, to April 1, 2017, to register.
Before September 2015, hedge funds were not regulated, although managers of hedge funds had to comply with the “fit and proper” criteria and obtain a licence in terms of the Financial Advisory and Intermediary Services Act. The regulations provide for two categories of hedge funds:
* Retail investor hedge funds (sometimes referred to as “hedge funds lite”), which have stricter controls than qualified hedge funds and are open to any investor; and
* Qualified investor hedge funds, which are available only to investors with more than R1 million to invest, who can demonstrate that they have sufficient expertise to understand the risks of hedge funds, or who invest through a financial adviser who has that expertise.
In terms of the new regulations, retail hedge funds’ investment strategies are restricted and funds are subject to oversight by the FSB. They are required to have independent trustees and to report regularly to investors, and the management company must monitor the risk in the funds.
What do hedge funds do that is different from other unit trust funds?
Unit trust funds can invest in cash, bonds, equities and, to a limited extent, some derivatives, which are intended to protect the portfolio when the market falls. Hedge funds largely invest in the same instruments, such as cash and listed bonds and equities, but they can use leverage and short selling, which other unit trust funds cannot do.
A key distinction between hedge funds and unit trusts is that hedge funds can invest 100 percent into cash, whereas unit trusts (unless they have a flexible investment mandate) are limited to 20 percent cash.
Ian Hamilton, the group chief executive officer of Investment Data Services (IDS), an administrator of hedge funds that has applied for approval as a hedge fund management company, says this means retail hedge funds are able to manage market risk far better than unit trusts, because the only way an investor in a unit trust fund can manage market corrections is to sell the unit trust. If this occurs within three years of purchase, the investor will be subject to income tax on the gains, rather than capital gains tax.
Hedge funds can also use gearing or borrowing to invest. In terms of the regulations, this option is restricted to 20 percent for retail funds, while there is no limit for qualified investor hedge funds.
However, through the use of derivatives, the portfolio can be geared or leveraged to 200 percent, which increases your investment risk and means the portfolio can incur losses that take it into a negative value.
Simon Peile, the head of investments at Sygnia Asset Management, says most of the leverage in hedge funds comes from short selling.
Short selling is when the fund manager uses derivatives to borrow a share and then sells it, promising to return the share to the lender at a future date. The manager expects the price of the security to fall. He or she will buy it in the market once the price has fallen and deliver it to the person or entity from whom the manager borrowed the share.
If you borrow a share and sell it, you receive cash, which can be used to buy more shares. A fund can buy shares for 100 percent of the capital invested, then short-sell shares to the value of 50 percent of the capital and use the proceeds to buy another 40 percent worth of shares. It is then 140-percent long and 50-percent short, resulting in a gross exposure of 190 percent (1.9 times leveraged) and a net exposure of 90-percent long.
Unit trust funds are not allowed to borrow an unlimited amount against the portfolio to have money to pay out investors if they want to disinvest. For this reason, most unit trust funds have at least five percent of the portfolio in cash, and this can cause funds to under-perform an index, such as the FTSE/JSE All Share Index (Alsi), when markets are rising and out-perform an index when they are falling.
The hedge fund regulations limit retail investor hedge funds to borrowing up to 10 percent of the portfolio to ensure there is sufficient liquidity to repay investors. Hedge funds for qualified investors do not have the same restriction, so it can take longer to redeem your investment.
There is also a limit on the percentage of a fund – 10 percent – that can be invested in a single security. This limit applies to all collective investment schemes, to reduce the risk of major loss if a single underlying investment fails.
If the portfolio includes derivatives, the manager must ensure that the fund’s exposure to derivatives does not exceed the net asset value of the portfolio.
Unit trust funds are not allowed to invest more than 10 percent in the shares of unlisted companies. A similar restriction applies to retail hedge funds, but if the unlisted instrument is a derivative that is independently valued, the fund can invest up to 20 percent in these instruments, as long as the fund still has enough liquidity to pay out investors. Qualified investor hedge funds do not have this restriction. However, they are not allowed to invest in physical property and private equity. They are also not allowed to invest in instruments that compromise the liquidity required for investors to cash in their investments.
The less stringent conditions on qualified investor hedge funds do not necessarily mean they can do anything within the permitted limits, because the FSB has to approve their investment mandates.
Hedge funds also differ from unit trust funds in the length of time the fund can take to pay you out (see “Is there a lock-in period?”, below).
How many regulated hedge funds have been launched so far?
Financial institutions that want to offer a regulated hedge fund have to register it in a collective investment scheme (the umbrella legal structure under which funds are registered) for hedge funds.
The FSB has so far approved only one collective investment scheme for hedge funds – a scheme registered by Novare – although IDS was hoping its scheme would be approved at the time of writing in March. The FSB reports that it has applications from 20 managers to set up hedge fund collective investment schemes.
In its collective investment scheme, Novare plans to launch 35 hedge fund portfolios this year, including 26 for individual investors, from a range of managers, including its own. These portfolios will include 10 funds of hedge funds – funds that invest in many individual hedge funds.
The FSB is expected to review and approve applications from all existing hedge funds that want to register by the third quarter of this year.
If you are in the market for a retail hedge fund, Peile says you should initially expect that only a small number of funds with credible track records will be available, because it will take time for investors to realise the advantages of these new funds.
Sygnia has three funds of hedge funds, providing you with the benefit of an experienced professional choosing which hedge funds to invest in and blending them into a portfolio.
Peile says most of the funds in which Sygnia currently invests have chosen to register as qualified investor hedge funds, and Sygnia will not therefore be able to offer its current funds of hedge funds as retail hedge funds.
He adds that Sygnia will not rush to launch a retail fund of hedge funds, but will wait until there are sufficient underlying retail funds to warrant a fund of funds that can add sufficient value. Investors may do well to wait until there is a selection of credible hedge funds in which to invest, he says.
Hamilton says he expects many traditional unit trust funds to convert to hedge funds and that most hedge fund managers will launch new funds as retail hedge funds, rather than as conventional unit trusts.
IDS plans to host 80 retail and qualified investor hedge funds.
Hamilton says Europe’s Undertakings for Collective Investment in Transferable Securities (Ucits) allows funds registered on collective investment schemes in Europe to short-sell shares in order to avoid losses, and many funds now offer this to investors. Because of the broader investment capabilities of funds in Europe registered under Ucits, a number of foreign funds registered in South Africa were forced to deregister, but the introduction of retail hedge funds in this country could see a number of them return.
The strategy adopted by funds that are “hedged” and target an “absolute return” is often misunderstood, he says.
Through the use of derivatives, a hedge fund can reduce the downside risk of a market falling, but this comes at the cost of reducing the upside of bull (rising) markets, he says. Although this means a “hedged” fund is likely to under-perform a fund that is not using hedging in a bull market, it also should out-perform funds that are not hedged when there is a bear (declining) market. Many institutions in Europe are investing in hedge funds simply to preserve capital against a collapse in financial markets.
Why might I want to invest in a hedge fund?
As hedge funds are intended to protect you in falling markets and provide returns that differ from non-hedge funds, you should not necessarily expect hedge funds to deliver spectacular returns when financial markets are rising.
Rene Miles, the managing director of Novare Wealth, a division of the Novare group, says the benefits of including hedge funds in your portfolio are the possibility of reducing volatility, increasing asset-class diversification, better capital preservation and stronger risk-adjusted returns.
Robert Foster, the convener of the hedge funds standing committee of the Association for Savings & Investment SA, says hedge funds are designed to out-perform the markets during times of extreme volatility, such as we experienced late last year. However, when financial markets perform well, hedge funds are unlikely to shoot out the lights, he says.
One of the main hedge fund strategies is equity long/short – in other words, an equity fund that invests by buying and holding shares and short-selling them. Foster says the index for this strategy, the HedgeNews Africa Long/Short Equity Index, delivered a return of 17.1 percent for the year to the end of December 2015, 15.1 percent a year over five years and 14.5 percent a year over seven years. In comparison, the Alsi achieved a return of 5.1 percent for the 12 months to the end of December 2015, 13 percent a year over five years and 16.4 percent a year over seven years.
Many investors are diversified across asset classes through multi-asset funds. The South African multi-asset medium-equity sub-category recorded average returns of 7.4 percent for the year to the end of December 2015, 10.6 percent a year over five years and 11.3 percent a year over seven years, Foster says.
Novare says South African hedge funds have been successful in protecting capital and minimising drawdowns (keeping the fall from peak to trough as low as possible), resulting in enhanced returns and lower risk in the overall portfolio.
Local hedge funds respond differently to market conditions compared with traditional asset classes, resulting in a low correlation with traditional asset classes such as shares, bonds and listed property.
Hedge fund managers also argue that they have a more sophisticated suite of investment instruments at their disposal than traditional managers and they can use these investments to minimise risk.
Offshore hedge funds are often in the headlines for all the wrong reasons – an example that is often cited is the United States-based Long-term Capital Manage-ment Fund, which lost US$4.6 billion in less than four months after the 1997 Asian and the 1998 Russian financial crises. To prevent widespread fall-out on Wall Street, the Federal Reserve (the US central bank) and 16 financial institutions put together a bail-out package for the fund.
Miles noted in an article last year that local hedge funds are largely conservative. He says they were initially established for institutional clients, such as retirement funds, and hence use far more conservative investment strategies and tend to be less exotic than the complex structures used globally.
Another advantage of South African hedge funds highlighted by Novare Investments analyst Yonela Makwetu is that they are still quite small in terms of assets under management and can therefore be quite nimble. She says some of South Africa’s unit trust fund managers oversee asset bases that are far larger than the entire hedge fund industry.
According to Novare, the hedge fund industry had assets under management of R62 billion in 2015. The largest hedge fund as of June 2015 had R5.3 billion in assets. The larger hedge funds – those with more than R1 billion in assets – performed better than the smaller funds over the year to June 2015.
There are many critics of hedge funds. Simon Lack, a US certified financial analyst and author of the book The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True is one of them. He says hedge fund exposure fails to deliver for investors because of exorbitant fees, high competition, the ineffectiveness of active investment management, and a general misunderstanding of the underlying exposures and correlations – that is, hedge funds don’t hedge. The purpose of hedge funds, from the perspective of the manager, parent company, consultants and brokerages, is to collect fees. In that sense, hedge funds have been a huge success, he says.
Lack describes the dramatic under-performance of hedge funds in the US as “pretty amazing” considering certain biases in the data used to compile hedge fund indices, which, he says, skew hedge fund returns upwards by three to five percent a year.
One such bias is survivorship bias: hedge fund indices reflect the returns earned by funds currently in the index, but omit the returns of funds that previously reported returns but have stopped reporting because of poor performance. The implication is that hedge funds report only when they are successful and stop reporting once they have a string of bad returns.
Then there is backfill bias, which has a dramatic impact on various hedge fund indices. Backfill bias occurs when an index provider adds a new fund to the index and “fills in” prior returns of that fund (which are presumably good). Hedge fund managers typically establish a fund with seed money (relatively limited start-up capital) and report the results only when the returns are sufficiently high to start marketing the fund. The result is a process that overstates returns, Lack says.
Lack’s analysis of the global hedge fund industry shows that hedge fund managers received 84 percent of the profits and fees generated by their funds from 1998 to 2014, whereas investors received only five percent, with funds of funds receiving the remaining share.
What is the level of risk?
Any fund you invest in exposes you to a level of risk in order to generate returns. The investment strategy determines the risks. With hedge funds, there are some unique risks, but the risks on which most people focus are those associated with leveraging or borrowing to invest.
The regulations under Cisca limit what retail hedge funds can borrow to invest to 20 percent of the fund, but qualified investor funds do not have these restrictions and in both funds the leveraging can be higher.
To understand the risks of leveraging, Peile says, consider what you do when you buy your first house. If you buy a R1 million house and put down a 10-percent deposit, you pay R100 000 and take out a R900 000 loan, so the deal is leveraged to the extent of R900 000. If the market falls 10 percent and you sell, you must still pay back R900 000 and you get nothing for what you put down as a deposit, so you lose 100 percent of your capital.
Leveraging is like driving a racing car: if it is driven by an experienced racing driver, your returns can be good, but if you allow an unlicensed 18-year-old to take the wheel, it could be dangerous, he says.
The Novare survey quotes the “value at risk”. Peile says value at risk simulates how the current portfolio would have behaved under various market conditions in the past and then quotes this as a statistical distribution – for example, 90 percent of the time you would have lost 10 percent of the fund’s value over any one month. Value at risk does not, however, give you any guarantee that you won’t incur larger losses.
Another risk measure investors use when considering hedge funds is the maximum drawdown, which shows the maximum amount the fund has lost previously from its highest peak to its lowest trough.
Measures of risk-adjusted returns, such as the Sharpe ratio, are also used to determine the risk relative to the performance of the fund. Peile says these statistical measures are based on past performance and so, ideally, the fund should have a long track record to make them meaningful.
Hamilton says hedge funds are perceived as “risky”, but this is a factor of the use of leveraging and, sometimes, concentration risk. However, gearing is limited in retail investor hedge funds, and concentration risk is reduced as a result of the limits on holdings as a percentage of the portfolio.
Qualified investor hedge funds have no such restrictions, but Hamilton says IDS will not host funds that it perceives as being very risky. This is because, if a hedge fund goes negative, the investors lose their money, but the management company is liable to the prime broker used by the fund for the excess loss.
Hedge funds can also face liquidity and pricing risks if the underlying investments prove difficult to sell because of contractual or market conditions, or if the assets cannot be valued accurately. In extreme market conditions, liquidity problems can cause a fund to collapse.
Using derivatives introduces counterparty risk – the risk that the counterparty may fail to meet its commitments.
Managers borrowing to invest also face the risk of not being able to borrow, or not being able to borrow at an acceptable rate, frustrating the strategy followed by the manager.
Like all fund managers, managers of hedge funds also face timing risk – the risk that the manager simply gets it wrong.
Are my retirement savings invested in hedge funds?
Retirement funds can invest in hedge funds, but regulation 28 of the Pension Funds Act (the regulation that is intended to ensure that retirement funds invest prudently) limits them to investing 10 percent of their assets in hedge funds and 2.5 percent in any one hedge fund.
Earlier this year, the Registrar of Pension Funds suggested that regulation 28 be amended so that retirement funds’ use of derivatives be restricted in the same way that retail investor hedge funds’ use of derivatives is restricted.
The proposed amendment to regulation 28 has drawn some criticism, particularly from Hamilton, who argues that, as long as regulation 28 limits the percentage of the portfolio that retirement funds can invest in hedge funds, there is no need to restrict them to investing in derivatives in the same way as funds offered to retail investors are restricted, because retail investors can invest all their money in hedge funds if they want to.
Peile says the proposed amendment to regulation 28 is likely to have a major impact on only two or three hedge fund managers.
Hamilton says retirement funds are nowhere near the 10-percent limit; if they were, they would have R300 billion in hedge funds, which is more than the assets of the entire hedge fund industry. He says many retirement funds have not invested in hedge funds, because they were unregulated.
Eugene Visagie, the head of hedge funds at Novare, says most South African retirement funds still prefer to invest via funds of hedge funds.
To what extent will the regulations protect me?
Peile says the introduction of regulated hedge funds should reduce the chances of things going badly wrong for hedge fund investors and thus improve the reputation of hedge funds and dispel some of investors’ doubts. However, he says, you can’t expect the regulations to protect you from poor returns.
Regulation, on its own, will make only a limited contribution to reducing risk for investors. Some unit trusts have reported significant losses from time to time, despite being regulated. Investors should try to have a good understanding of how the fund operates before they invest, Peile says.
A recent example of a unit trust fund with a high exposure to derivatives that incurred large losses is the MetCI Third Circle Target Return Fund, a South African multi-asset flexible fund, which lost almost 60 percent of its value over the quarter to the end of December 2015.
Peile says Sygnia has been comfortable investing in unregulated hedge funds, because the company has a lot of experience and knows what to expect from hedge funds. Much depends on the hedge fund strategy you choose, but choosing the right funds can result in hedge funds playing a useful diversification role and giving you a “sleep-well factor”, because your returns will be smoother, Peile says.
He says the range of returns can be very wide with conventional unit trust funds. A specialist fund may return anything from minus 40 percent to plus 40 percent, but unit trust funds that invest in a particular sector of the market tend to earn similar returns.
With hedge funds, there isn’t a market return, or beta; the range of returns depends on the investment strategy of the fund. The absolute range of returns you will find among hedge funds could be higher than it will be for all unit trust funds in the same investment-strategy category, but is likely to be smaller than it is for all unit trusts once one includes all the specialist strategies.
The introduction of regulated hedge funds changes things, because it is likely that many funds will be introduced by financial institutions that are known to be in the business of increasing their assets under management, Peile says. This is contrary to what most hedge fund managers aim to do: gather just the right amount of money to manage.
Hamilton says that, because hedge funds earn their performance fees by out-performing their benchmarks, they are cautious about taking in money when they may struggle to find investment opportunities and may close to new investors.
If institutions launch funds of hedge funds, they are likely to chase investor money, because they earn fees based on assets under management. This in turn may create a problem for the single managers who may not want extra money from the funds of hedge funds, Hamilton says.
Peile says you can’t look at what the industry has been doing in the past and expect retail hedge funds to perform the same way, because many will be new products.
Is this a South African fund?
If an offshore hedge fund wants to market itself in South Africa, it has to register with the FSB and comply with the hedge fund regulations. This does not mean you cannot invest directly in an unregistered offshore hedge fund using your foreign currency allowances, but you should be aware that it may not be regulated in the same way as funds are regulated here and may therefore be more risky. There may also be no contact person in South Africa, if you have administrative problems.
What investment strategy does the fund use?
Novare conducts an annual survey among hedge fund managers. Participation is voluntary, but Novare believes the participants in its survey manage the bulk of hedge fund assets. According to the Novare survey, most South African hedge funds (60 percent) are equity long/short funds, but there are also fixed-income hedge funds, equity market-neutral funds and multi-strategy funds. There are also funds that invest mainly in commodities or listed property.
Equity long/short funds buy and hold some stocks and short others when they think the price is going to fall. Equity market-neutral funds appear to be similar to equity long/short funds, because they also take long and short positions, but, while most funds aim to deliver a return that beats the market by a certain number of percentage points, equity-neutral funds aim to achieve an absolute return that does not depend on the direction of equity market returns.
Peile says equity-neutral funds often execute pair trades, where they go long and short in similar amounts in two closely related stocks. They go long in the one they think is relatively cheap and short the one they think is relatively expensive, hoping to profit if the gap closes, irrespective of whether the market as a whole goes up or down. Visagie says the managers of equity-neutral funds need specialist skills to implement the strategy successfully.
Fixed-income hedge funds take advantage of inefficient pricing in the fixed-interest markets in order to deliver a good return even when interest rates are rising. Multi-strategy funds use a variety of underlying hedge fund strategies.
Visagie says South Africa does not have the exotic derivatives that US and European markets have and hence there are fewer strategies among local hedge funds than in offshore markets.
Hamilton says it is likely to be some time before the different investment strategies are categorised so that funds with the same strategies can be compared to one another.
Under what structure does the fund operate?
The hedge fund regulations permit funds to have one of two legal structures. They can either have a collective investment scheme trust arrangement or they can have an “en commandite” partnership. This kind of partnership includes one partner, the management company, whose name is disclosed and whose liability to the co-partners is unlimited, while the names of the other partners, the investors, are not disclosed. This limits their liability to the amount they put into the fund. In other words, the other partners are not at risk of suffering a loss or liability in excess of their investment in, or contractual commitment to, the partnership.
Peile says most hedge funds have, to date, used the en commandite structure to enable them to pool investors’ funds, because they had no other choice, but most will now convert to the trust structure used by unit trust funds. Visagie says this is because investors are more familiar with the collective investment scheme trust structure. Hamilton says an en commandite partnership will be onerous and expensive to maintain under the new regulations.
What experience do managers have in the hedge fund industry?
According to Novare’s survey, 39.8 percent of the assets under management in the hedge fund industry are managed by managers with more than 10 years’ experience of managing these funds.
Peile says a manager should have a track record of at least three years, and, ideally, one that shows how the manager performs through both up and down market cycles. If a manager has been running a qualified hedge fund and then launches a retail fund, you can consider his or her track record as a qualified hedge fund manager.
Both Peile and Visagie say that if a large financial institution without any experience of managing hedge funds starts a hedge fund, you can’t consider its experience in managing other assets as an indication that it will do as well with a hedge fund. What you want to see, Peile says, is whether the return profile achieved to date can be replicated into the future and for this you need to consider both the track record and a description of what the fund does.
Should you look for a fund of hedge funds?
A fund of hedge funds is a fund made up of underlying funds. The manager’s job is to select and blend the best underlying funds.
According to the Novare survey, R37 billion of the R62 billion in individual South African hedge funds is invested through funds of hedge funds.
As an individual investor, you may find it difficult to understand what to expect from any one hedge fund and a fund of funds may therefore be a better choice, Peile says.
Funds of hedge funds offer you diversification and manage your risk better, to ensure a more consistent return, he says. They do, however, involve another layer of fees, because you have to pay not only the underlying fund managers, but also the manager of the fund of funds.
Caveo, Edge, Novare, Old Mutual Multimanagers, Sygnia and some wealth managers offer funds of hedge funds.
Overseas funds of funds may invest in up to 50 hedge funds, but this is not practical in South Africa, and Sygnia has between 15 and 20 underlying hedge funds in its fund of funds.
Peile says most of the returns earned by funds that invest long only is explained by the return of the market, or beta. But in the case of hedge funds, there is no beta, and the funds generate returns based on the strategies followed by the particular managers of that fund. This means there is a higher level of “idiosyncratic”, or unique, risk and it makes sense to diversify among funds to reduce risk, Peile says.
For example, if you invest equally in 10 funds and one of them is subject to a “black swan” event (unpredictable, extremely negative performance), you could lose 10 percent of the overall value of the fund, but if you have 50 underlying funds, you will not lose more than two percent of the fund. Fund of fund managers also blend complementary strategies to ensure you have maximum diversification.
Although the regulations allow funds of hedge funds, they do not allow multi-asset unit trust funds to include an allocation to regulated hedge funds. This is unfortunate, Peile says, because the retail investor should invest in hedge funds to create more diversification within a multi-asset portfolio.
Before you invest in a fund of funds, find out how many underlying funds there are and ask how the underlying funds are blended, to ensure that their investment strategies are not correlated but produce diverse returns.
How much will I pay in fees?
According to popular hedge fund lore, most funds charge according to the “two-and-20 rule”, which means an annual fee of two percent and a performance fee of 20 percent of all performance above a particular hurdle (the level of performance the fund must achieve before it charges a performance fee). But the 2015 survey of hedge funds conducted by Novare reveals that the most popular fee structure for South African funds is a management fee of one percent and a performance fee of 20 percent – some 52 percent of managers charge this combination of fees.
Peile says that, generally, hedge funds are expensive and paying these fees is justified only if the fund delivers returns that you can’t receive elsewhere. You should expect a better return for the risk you take.
He is of the view that retail hedge funds will be under pressure to charge less than a one-percent management fee plus a 20-percent performance fee. Existing hedge funds that qualify as retail funds are unlikely to reduce their fees, but new funds are likely to come in at a lower fee, and retail funds of funds will also have to lower their fees, he says.
When you assess the fees a hedge fund charges, you need to establish:
* What is the annual management fee?
* What is the performance hurdle? What is the measurement period for the hurdle and what fee applies above the hurdle?
The Novare survey indicates that more than 70 percent of hedge funds use the return you can earn on a cash investment as a hurdle. In other words, they charge a performance fee for any return earned above what you could obtain in a very low-risk money market investment.
* Is the performance fee uncapped? Novare says 90 percent of assets in the hedge fund industry are in funds with uncapped performance fees. This means that, regardless of how high the return, you will pay the performance fee – for example, 20 percent – on the portion above the hurdle.
* What happens to the performance fee when performance is negative – is some of the fee paid back to the investor (clawed back)? The Novare survey notes that almost 16 percent of hedge fund assets are in funds with claw backs.
Performance fees are complex, and you may need professional advice to establish whether the potential return is likely to justify the fees.
Hedge funds are now, like other collective investment schemes, obliged to report their total expense ratios (TERs). Remember that TERs are a backward-looking measure of costs and will be high when the performance of a fund has been good.
If you are considering investing in a fund of hedge funds, Peile says you should be aware that the fees, on top of the fees of the underlying funds, will look “horrendous” in comparison to any conventional TER. So, if all you are looking for is a low fee, you should look at an investment other than a hedge fund, he says. A hedge fund that is worth investing in will have a good after-fee return.
Hamilton says hedge fund managers charge higher fees than long-only managers. This is because they need to cover risk management requirements. At the same time, there are few opportunities to achieve economies of scale, because many hedge fund strategies have size limitations, he says.
For many of the fund managers, it is simply not viable to own and run their own hedge fund management companies, and they are able to come to market only through another management company that has a collective investment scheme licence. A third-party manager involves another layer of costs, Hamilton says. Although costs should not be ignored, he says, your focus should be on performance after fees when you are comparing funds.
He says long-only fund managers’ profits are often based on the growth in the portfolio generating more fees, whereas hedge fund managers do not derive their profits from growing their assets, but from fees and performance fees obtained by out-performing real-return benchmarks.
Is there a lock-in period?
Unit trust funds have to redeem your investments within 48 hours, but hedge funds sometimes need longer to unwind their investments and use of derivatives. The regulations for hedge funds therefore require retail hedge funds to allow you to redeem your investment on a calendar month’s notice, while qualified funds must allow you to redeem your investment on three months’ notice.
Hamilton says most hedge funds will set their own redemption terms, which are likely to be shorter than the maximum periods allowed by the regulations.
Hedge funds can also use lock-ins when you invest, in terms of which you cannot redeem your investment for a certain period, such as three months.
After the initial investment period and once the lock-in has expired, the redemption period comes into effect.
According to the 2015 Novare survey, no funds had investment lock-in periods of longer than three months during the survey period, and 90 percent had a 30-day period. The Novare survey notes that most funds (96.9 percent) have no initial investment lock-in period. Offshore hedge funds have other limitations on your withdrawals from the fund, such as penalty or exit fees.
Hamilton says that, although qualified investor hedge funds may consider adopting some of these limitations, it is highly unlikely that they will implement any of them.
What is a fund’s performance track record?
Typically, to determine a fund’s track record, you need to decide on a suitable benchmark against which to measure that performance.
Peile says you shouldn’t measure a hedge fund against an index such as the Alsi over the short term.
Many of the indices used for hedge funds are those in which hedge funds participate voluntarily and their performance cannot be replicated. The performance of an index such as the Alsi can be replicated, because you can buy the shares that make up the index, but you can’t do the same with a hedge fund index, because it is made up of different hedge funds following different investment strategies and investing in different underlying assets.
Over the long-term, it might be interesting to see how hedge funds perform relative to the share market, Peile says, but cash is typically the benchmark against which hedge funds compare their performance, because they aim to deliver a positive return at all times. But a return equal to, or just above, cash is not a good return for a long-term investor, because it will not compensate you for the risks to which you are exposed.
Peile says if a hedge fund has more long positions, it will have some sensitivity to the direction of the market, so a combination of cash and equities might be good.
Who monitors the risks in the fund?
The hedge fund regulations require managers to have what is known as a risk management policy to manage operational risk, business risk, liquidity risk and credit counterparty risk. These risks have to be measured and tested under various scenarios, and the manager has to ensure that the fund complies with the limits on exposure to, for example, leveraging.
Peile says some funds outsource risk management and some do it inhouse, but individual investors won’t be able to judge how effective a fund’s risk management is unless the fund performs very poorly.
Which company administers the fund?
The Novare survey reveals that two service providers administer 90 percent of the hedge fund industry’s assets. The two companies are IDS and Maitland.
Hamilton says many hedge funds will in future be hosted on what is known as a white-label basis by third-party management companies.
He says the FSB is being very strict in its approval of management companies that can host hedge funds on their schemes. One of the main criteria that funds need to meet is the ability to manage the risk of the hedge funds.
Many companies have applied for approval on the basis that they have unit trust management companies, but comparing the administration required for a unit trust management company to that required for a hedge fund is like comparing a bicycle licence to a licence for a heavy-duty vehicle, Hamilton says.
He says good risk management does not mean that funds, even retail hedge funds, cannot incur large losses, but it is less likely. This protection, however, comes at an additional cost, he says.
Are the fund’s holdings disclosed daily?
The regulations for hedge funds under Cisca state only that hedge funds must disclose all their assets to the FSB quarterly.
The Novare survey shows that 57 percent of funds disclose their actual holdings to investors daily.
Peile says many funds disclose their holdings to institutional investors and fund of hedge fund managers, but this does not mean the holdings will be published for the benefit of retail investors. Managers are very protective of this information, because they see it as their “secret sauce”, he says.
Will the fund close if it gets too big?
The Novare survey notes that, of the funds surveyed, 7.1 percent had closed to new business and 9.5 percent were accepting investments only from existing investors (this is known as soft closed).
You should take comfort in the fact that a fund has a policy to close when it gets too big to be able to carry out its investment strategy effectively.
Peile says hedge funds should be in the performance game rather than the asset-gathering game. Hedge funds earn their fees based on their performance, whereas many unit trust funds that do not charge performance fees allow their funds to grow very large in order to earn large revenues from fees.
It is difficult for you, as an ordinary investor, to know the capacity for a hedge fund’s strategy and to be certain that a manager will close a fund once it gets too large.
Why should we believe this fund is here for the long term?
The hedge fund industry is often criticised for quoting returns without citing the funds that failed to survive.
Only one South African hedge fund has failed: the Evercrest fund that failed about 10 years ago after losing about two-thirds of investors’ money.
But hedge funds are also dissolved, and the capital is returned to investors.
The Novare survey shows seven funds were dissolved in 2014 and six in 2015, including one of the country’s largest funds, which closed because it was not compliant with the hedge fund regulations.
Peile says funds are dissolved for different reasons, which include the fund managing emigrating, the proposition never taking off and the fund disappointing investors as a result of poor performance and poor risk management.
Large institutions may dissolve hedge funds if they believe the funds are not successful and they can employ the managers who run these funds better on other funds.
Peile says there are advantages to investing with a boutique manager, because these managers go under if they disappoint their investors, so a boutique manager carries more risk and therefore takes risk management more seriously.
He says having the manager of a fund of funds choose the underlying fund managers means that an experienced professional conducts a due diligence on the underlying funds and assesses the probability of their failing or being dissolved.