Illustration: Colin Daniel/Istock/Shutterstock

This article was first published in the fourth quarter 2016 edition of Personal Finance magazine.


Unit trust funds can use derivatives to provide insurance against market falls, so an asset manager should, in theory, be able to use these instruments to provide you with what is known as hedged equity exposure – equity exposure that captures positive returns but has protection against losses.

But achieving positive returns without paying too much for protection is not as simple as it seems, as funds that specialise in offering this kind of equity protection show. Only a handful of funds market themselves as actively using hedging – to the extent to which they are allowed without being classified as hedge funds in terms of the legislation governing unit trust funds, the Collective Investment Schemes Control Act (Cisca). These funds often use the terms “protected equity” or “dynamic floor” in their names. It isn’t easy to find funds that have consistently delivered on their mandates and have a proven track record of protecting against market falls.


Derivatives and hedge funds

Derivatives are contracts between two or more parties whose value is derived from the value of an underlying security, such as a share or bond. They include futures (a contract to buy or sell with a delivery date in the future) and options, which give you the right either to buy (a call option) or sell (a put option) securities at a fixed price at a future date.

Hedge fund managers are the only managers who are entitled to use derivatives to increase a fund’s exposure to risk and hence multiply the returns and/or the losses – known as gearing.

Managers whose funds are not registered as hedge funds can use derivatives only to protect the fund from losses – in what is known as a “covered” position. This means the fund can take out derivatives only on the shares or other securities it actually owns, to protect from losses if the value of that share, security, or basket of shares or securities, should fall.

In terms of a notice under Cisca, exposure to derivatives, as well as to the actual securities (shares and bonds) being protected, must be less than the market value of a (non-hedge-fund) unit trust fund.

At all times, if the fund uses derivatives to short a share (in other words, to lock in the value of a share that it believes is likely to fall), it must own the shares and be able to deliver them if it has to, or it must have the cash to buy shares if it takes an option to buy.

The notice also says that, if a fund owns a derivative on an index, it must maintain exposure to the assets in the index that is “highly correlated” or similar to the index.

Hedge funds, on the other hand, can use derivatives in what is known as a “naked” position – they can short shares they do not own.

Hedge funds are now obliged to register in terms of Cisca, but you can invest in hedge funds that are allowed to take the most risk only if you are a qualified investor – in other words, you have more than R1 million to invest and are either aware of the risks or have a financial adviser who is.

What are known as “hedge funds lite”, or retail investor hedge funds, are allowed to gear (borrow) up to 20 percent of the fund.


Scant protection?

Despite the protection provided by legislation, the recent example of a loss of close to 60 percent over the quarter to the end of December 2015 in Third Circle’s Target Return Fund is cause for concern. The fund had a protected equity strategy and was one of four Third Circle funds that were intended to be building blocks for two funds of funds.

The losses were incurred in the month in which Nhlanhla Nene was fired as finance minister. Third Circle fund manager Ian Lane described this as a “black swan” event (an extreme event that was unlikely and unpredictable).

Third Circle operated what are known as white-label funds: it did not have its own collective investment scheme licence, but used the licence of Metropolitan Collective Investments (MetCI), which was ultimately responsible for the funds’ compliance with Cisca.

MetCI investigated the dramatic loss in the Target Return Fund, and at the end of July 2016, announced that it was taking over the management of the fund, as well as Third Circle’s five other funds.

Braam Jordaan, from MetCI, says MetCI’s investigation found that the derivatives held by the fund were not covered by the securities held in the fund; as a result, the portfolio was geared.

Jordaan says the information provided by the manager on the positions held by the fund complied with industry practice, but was inadequate for MetCI to gain deep insight into the risk exposure of the fund.

MetCI has now employed an independent risk management company to provide an additional risk analysis service on an ongoing basis and ensure deeper insight into managers’ exposure.

Many fund managers use derivatives to protect their funds against market losses, but few use them as part of a core strategy in the way that protected equity or dynamic floor funds do.

Fund fact sheets and other minimum-disclosure documents do not always reveal which funds actively use derivatives (or hedging) to protect their equity exposure against market falls. In fact, the trust deed of a fund should stipulate that it can use a hedging strategy, and the use of derivatives should be stated in its minimum-disclosure document.

Protected equity is a strategy that provides a unique risk-and-return profile that differs from that of shares, bonds or cash. It is one that retirement funds and other institutional investors know how to use, according to Deslin Naidoo, the head of investment research at Alexander Forbes. For retirement funds, the attraction of using protected equity strategies is that they complement a broader multi-asset strategy, so the fund can better match its liabilities to pay pensions, he says.

Unit trust funds that use protected equity strategies should be able to offer the same benefit to individual investors, but they haven’t attracted large amounts of investors’ money, compared with funds in the multi-asset flexible or multi-asset high-equity sub-categories. Two protected equity funds that launched as equity-only funds with hedging have since changed their mandates to invest across asset classes, and a third fund is considering a similar change.

Naidoo says funds that invest only in equities and use derivatives to protect against losses are designed to be used as one building block in a diversified investment portfolio. However, he says investors are not using them in this way, and managers are now seeing the value of offering multi-asset funds that include a protected equity strategy.

A protected equity fund typically seeks to provide you with two-thirds of any positive returns from the market and only one-third of any negative returns, according to Naidoo. Over a 10-year market cycle, this should deliver better risk-adjusted returns than a fund without a protected equity strategy, he says.

JC Louw, the manager of the Contego B5 Protected Equity Fund, agrees that, for every one step down in returns from a protected equity fund, the returns should take two steps up. He says investors should be aware that if the market drops by, for example, 10 percent in a quarter, the B5 Fund will save only seven percent, because it spends about three percent on the derivative protection.

Protected equities can be used to change the risk profile of a multi-asset investment, Naidoo says. Assume, for example, that you need a multi-asset portfolio with an exposure of 50 percent to equities and the rest in lower-risk assets in order to earn the return you need without taking more risk than you can afford.

You could increase the exposure to equities to 75 percent and take out protection on those equities so that the risk exposure of the portfolio remains at the same level as the original 50-percent-equity portfolio. This should result in a portfolio that out-performs the 50-percent-equity strategy, Naidoo says.

However, you need to bear in mind that the cost of taking out such “insurance” can be high. Furthermore, at times like the present – when the equity market has experienced a bull run – the performance track record of funds that use derivatives for hedging relative to that of equity or multi-asset funds that do not pay for protection or rely largely on asset allocation to protect against downfalls, is less than stellar.

Bastian Teichgreeber, the manager of Prescient’s protected equity funds, says investing in derivatives can cost 2.5 percent a quarter, or 10 percent a year of the protected equities. If markets move up quickly, a protected fund can capture only 60 percent of the positive return, but if markets are moving up slowly, you can capture 100 percent of that return, he says.

Teichgreeber says the cost of protection is key, because it detracts from positive performance, but there are ways to lower the costs. One way is to ensure you look for “sweet spots” in market volatility and buy protection only when the protection is cheap. The cost of protection increases as volatility increases, so before and after the United Kingdom’s Brexit vote in July this year, for example, the market was volatile and protection was expensive, Teichgreeber says.

Another way is to give up some of the positive returns in exchange for protection against losses, Teichgreeber says. For example, you could agree to earn the positive returns from the FTSE/JSE Top 40 Index up to 10 percent, and if the index returns more than that in a particular quarter, you will not participate in those returns.

Louw says if you buy a put option on the Top 40 Index at its September level of 46 000, set to expire in December, the premium would be 3.4 percent, or R3.40 of every R100 of equities you buy. The market would have to drop to 44 400 before you would start making money. However, over the years, the Contego team has developed innovative ways to reduce this cost to less than two percent.

Louw says that using a protected equity fund, as opposed to investing in a largely unprotected equity fund, is like climbing a rock face with belays, which are the pins to which the ropes are attached, versus climbing without them: the climber with the belays may be slower, but he should fall only as low as the last belay, whereas the climber without the belays moves fast, but risks falling all the way down.

The protected equity strategy also means that when the market crashes, as it did in 2008, a protected index-tracking fund will recover from a much higher base and reach its previous highs in a much shorter time than an unprotected fund.

You lose two to three percentage points of your returns through the premium you pay for the insurance provided by a protected equity fund, and there is no guarantee that the premium will pay off for you, Louw says. So your basket of shares has to perform fairly well to make it worth incurring the cost of investing in a protected equity fund. For example, if your equity portfolio delivers a return of 15 percent over any given period, while the Top 40 Index returns only 12 percent, you will have out-performed the index by three percentage points, but once the cost of taking out protection has been deducted, your net gain will be in line with that of the index, Louw says.

Some of the longer-standing protected equity funds are Prescient’s Protected Equity Fund and its Positive Return Quant Plus Fund, the Old Mutual Dynamic Floor Fund, the Contego B5 Protected Equity Fund, the Kagiso Protected Fund, the Cadiz Equity Ladder Fund and the Momentum Capital Enhancer Fund. A quick look at the mandates, investment philosophy and performance of these funds highlights just how diverse these offerings are.


Prescient Equity Defender Fund

Unit trust fund classification: South African multi-asset flexible sub-category

Targeted return: equity-like returns/Consumer Price Index (CPI) plus six percentage points

Return over three years to June 30, 2016: 6.38 percent a year

Rank in sub-category: 45th out 54 funds over three years to June 30, 2016

Average return for the sub-category: 10.21 percent a year over three years to June 30, 2016

Targeted risk protection: lower losses than the equity market

Risk target achieved: always

Although the Equity Defender Fund is a multi-asset flexible fund, it has almost 100-percent exposure to equities and has protection against market falls that reduces its effective exposure to equities.

The fund has a composite benchmark, made up of 70 percent of the Top 40 Index and 30 percent of the Alexander Forbes Short-term Fixed-interest Index. Since inception, the fund has under-performed this composite benchmark by 6.61 percent a year. Teichgreeber says this is a result of the cost of derivatives in markets that are moving up, plus the fact that the fund does not invest offshore.

Because the Equity Defender Fund’s returns are driven by the equity market, it is advisable to invest in the fund throughout the cycle for five to seven years. The fund is structured not to lose money over any rolling 12-month period, which is “very special” for any fund that earns equity-market-related returns, according to Teichgreeber. He says the fund didn’t have any negative returns during the European sovereign debt crisis in 2011 or the global financial crisis in 2008 and has had no negative 12-month periods since the inception of the strategy in 1998 (the unit trust launched only in 2002).

He says 2009 and the past three to five years have been difficult for the fund and it did not capture as much of the positive returns as promised. The fund has therefore failed to meet its target of CPI plus six percentage points.


Prescient Positive Return QuantPlus Fund

Unit trust fund classification: South African multi-asset medium-equity sub-category (up to 60 percent in equities)

Targeted return: CPI plus four percentage points

Return over 10 years to June 30, 2016: 7.92 percent a year (inflation has averaged 6.18 percent)

Rank in sub-category: 20th out 23 funds over 10 years to June 30, 2016

Average return for the sub-category: 9.08 percent a year over 10 years to June 30, 2016

Targeted risk protection: the fund aims to avoid losses over any rolling 12-month period

Risk target achieved: yes, over 10 years

The Prescient Positive Return QuantPlus Fund is classified as a multi-asset medium-equity fund, but it behaves more like a conservative balanced fund with less than 40 percent in equities, Teichgreeber, who is the manager of the fund, says.

Unlike other multi-asset funds that allocate sizeable amounts to bonds, listed property and cash, the fund has a very high exposure to equities of up to 97 percent, but, as a result of its derivative protection, its effective exposure is below 40 percent. Losses are avoided, but the derivative exposure means that some of the positive returns from the equity exposure are lost, and this has resulted in the fund not meeting its targeted return.

The fund has, however, delivered on its promise not to incur losses over any rolling 12-month period since its inception in 2004. Its lowest return over this period is 1.58 percent, and its worst losses from peak to trough have been minus 4.49 percent.

According to Teichgreeber, the fund’s equity exposure is currently just below 30 percent. Prescient is being cautious, because it believes we are in the late stage of the global business cycle and that equities are expensive. This means that, if equities lose money, your loss will be contained to that percentage loss on 20 percent of your portfolio.


Contego B5 MET Protected Equity Fund

Unit trust fund classification: South African multi-asset flexible sub-category

Targeted return: CPI plus four percentage points

Return over 10 years to June 30, 2016: 8.53 percent a year (inflation has averaged 6.18 percent a year over this period)

Rank in sub-category: 18th out 29 funds over 10 years to June 30, 2016

Average return for the sub-category: 10.21 percent a year over 10 years to June 30, 2016

Targeted risk protection: the fund aims to deliver positive returns where possible

Risk target achieved: yes, over all periods

The Contego B5 MET Protected Equity Fund invests in a basket of shares and holds protection against losses on the Top 40 Index at all times. Louw says the fund aims to have more than 90 percent in equities at all times, and the tracking error between the shares held and the protection is less than 2.5 percent.

Currently, the fund has 90.1 percent in equities, but its effective exposure is 79 percent.

Despite derivatives reducing the fund’s equity exposure by more than 10 percent, the cash required for the exposure to the futures (the initial margin) is less than one percent of the fund, Louw says.

The Contego B5 MET Equity Fund has not met its performance target over various periods to the end of June this year. Louw says this is a particularly bad time to look at the performance of any equity fund, because, first, the firing of Nene at the end of last year caused losses on the share market; second, the rand appreciated against the United States dollar, causing losses for any portfolio positioned for a weak rand, and, third, resource shares rallied in the first two months of the year, which normally doesn’t happen when the rand is strong.

In addition, any fund that was exposed to listed property when the UK voted to leave the European Union in June would have delivered poor results.

The local share market has gone sideways – neither up nor down – over the past two years – a difficult time for most funds, but particularly for protected funds that rely on volatility in the market to extract value from derivatives, Louw says.

From 2007 until the end of 2009, the fund did very well, he says – in fact, it was top of its sub-category in 2007, the last year of the bull run that ended with the global financial crisis of 2008. Last year, the fund also did really well, despite making only small gains in the FTSE/JSE All Share Index (Alsi).

The best time to judge the value of hedging on an equity portfolio is when markets are volatile, Louw says. During periods of low volatility, the cost of derivatives is generally a drag on performance, he says.

Despite the fund’s failure to deliver on its target, he says now is a good time to consider investing in a protected equity fund. There is currently a high level of uncertainty and risk in global markets, and Contego expects a lot of volatility over the next 12 months.

Louw says if the volatility of the market, as measured by standard deviation, is 20 percent, then at some stage during any year the market will go down by about 10 percent.

Some managers take out protection as and when they believe it is necessary, but no manager can predict when the market will fall, Louw says. It is for this reason that the B5 Fund is always fully protected.

Some managers protect their funds only against falls of, for example, more than 10 percent. But this means that if the market falls by, say, eight percent, the protection adds no value.

Contego manages a pure South African equity fund, the Contego B7 MET Equity Growth Fund, which has the same basket of shares as the B5 Protected Equity Fund. It uses derivatives to manage its cash component, and call options to smooth returns and out-perform its benchmark.

The Growth Fund’s three-year track record to the end of June this year shows that it returned 10.78 percent a year over this period, compared with the Protected Equity Fund, which returned 8.83 percent a year over the same period.


Kagiso Protector Fund

Unit trust fund classification: South African multi-asset medium-equity sub-category

Targeted return: CPI plus five percentage points

Return over 10 years to June 30, 2016: 7.42 percent a year (inflation has averaged 6.18 percent a year over this period)

Rank in sub-category: 23rd out 23 funds over 10 years to June 30, 2016

Average return for the sub-category: 9.08 percent a year over 10 years to June 30, 2016

Targeted risk protection: none

Risk target achieved: n/a

The Kagiso Asset Management’s Protector Fund returned 7.42 percent a year, versus its benchmark’s 11.2 percent a year, over 10 years. It has under-performed its benchmark over all periods. Its maximum drawdown has been minus 20 percent, and it has achieved positive returns in 64 percent of the months since its inception in 2005.

Justin Floor, the manager of the fund, says Kagiso expected the fund to deliver better returns. Kagiso’s stock selection did not work well in 2014 and 2015, because key stock picks, such as platinum mining equities and mid-cap shares, such as Tongaat, AECO, Adcorp and Metair, under-performed substantially.

A few years ago, the fund’s strategy changed from a pure protected equity fund to a conservative balanced fund with less emphasis on hedging, he says.

Floor says Kagiso has introduced asset allocation and a wider investment universe that extends to cash, bonds, property and international equities, to meet the fund’s dual objectives of delivering above-inflation returns and prioritising capital protection.

Although derivatives are no longer a core strategy, the fund uses them tactically from time to time – for example, when the UK voted to leave the EU, he says.

When the fund does use derivatives, it uses a combination of futures and put options on the Top 40 Index, Floor says. The costs of using this protection are the opportunity cost in lost performance if the manager makes the wrong call on when the market is likely to fall, and the cost of the premiums for the protection, he says.

Kagiso focuses on the valuation of the securities in which it invests – in other words, it seeks to buy securities, including option protection, when the price is low relative to the expected returns. The cost of the protection is linked to how long the protection is in place and how much volatility investors in the financial markets expect in future.


Old Mutual Dynamic Floor Fund

Unit trust fund classification: South African multi-asset medium equity sub-category (the fund complies with regulation 28 of the Pension Funds Act)

Targeted return: CPI plus three to four percentage points

Return over 10 years to June 30, 2016: 9.05 percent a year (CPI has averaged 6.18 percent over this period)

Rank in sub-category: 14th out of 23 over 10 years to June 30, 2016

Average return for the sub-category: 9.08 percent a year over 10 years to June 30, 2016

Targeted risk protection: the fund aims to protect at least 90 percent of the investment over a 12-month period

Risk target achieved: yes, the lowest one-year return was minus 4.9 percent

The Old Mutual Dynamic Floor Fund invests in both growth assets, such as shares listed locally and globally, and safe assets, such as cash, money market instruments and, to some extent, bonds.

The fund uses asset allocation in what it refers to as a “dynamic protection strategy” to avoid the high costs of hedging. The management of the fund is primarily driven by a predetermined level, or floor, which is also the risk target of the fund.

When markets are rising, the fund increases its exposure to growth assets, such as equities, to improve its participation in positive returns. In falling markets, the fund regularly reduces its exposure to growth assets. This helps to ensure that the fund does not lose more than 10 percent over any rolling one-year period. The fund may use derivatives to manage and limit the risk of losses, and also to capture or lock in gains in a cost-effective manner.

The fund’s return target is CPI plus three to four percentage points a year (before fees) over an investment term of three to five years.

The fund has had a maximum drop in value of minus 4.9 percent since inception in November 2002, as opposed to the Alsi’s minus 37.6 percent over the same period and the All Bond Index’s minus 5.7 percent.

One of the fund’s managers, Hanno Niehaus, says, in a bear market, a balanced fund can suffer losses of up to 33 percentage points over a one-year period. The Old Mutual Dynamic Floor Fund, however, out-performed most balanced funds by a substantial margin in the 2002/3 bear market, he says. Between June 2008 and March 2009, the Alsi fell 40 percentage points and the average balanced fund went down 22 percentage points. The Dynamic Floor Fund fell only three percentage points and was able to increase its equity exposure thereafter, delivering good returns during the bull market, Niehaus says.

Systematically buying put options every quarter in a “normal” market without significant volatility would cost the fund about 13 percent of the amount hedged per year, he says. Using dynamic hedging, however, avoids these large upfront costs and adds to the fund’s risk-adjusted returns.


Cadiz Equity Ladder Fund

Unit trust fund classification: South African multi-asset flexible sub-category

Targeted return: CPI plus six percentage points

Return over 10 years to June 30, 2016: 7.07 percent a year (inflation has averaged 6.18 percent over this period)

Rank in sub-category: 24th out of 29 funds over 10 years to June 30, 2016

Average return for the sub-category: 9.08 percent a year over 10 years to June 30, 2016

Targeted risk protection: low risk of permanent capital loss

Risk target achieved: shows a small loss over five years

One of the top-performing funds after the 2008 global financial crisis was the Cadiz Equity Ladder Fund. It returned about 11 percent in 2008, whereas most other funds were showing losses, and a year later it returned more than 30 percent. But it hasn’t been able to repeat that performance. In its heyday, it had about R1.2 billion invested, but it has since shrunk to a tenth of its size, at R98 million.

Graeme Ronne, the fund’s manager at Cadiz, says the Equity Ladder Fund has historically been a long equity fund with protection taken through a hedging strategy. However, the fund’s strategy has changed and it is currently managed as a flexible asset allocation fund.

Ronne says the fund varies the asset allocation and uses derivatives tactically to generate the targeted risk-adjusted return profile. The fund currently has a net equity exposure of 70 percent.

The fund’s risk profile now falls between medium risk (like the multi-asset medium- equity funds) and high risk (equity-only funds). The fund has not reached its target of CPI plus six percentage points over any period since its inception in 2006.

The past few years have been particularly difficult, Ronne says, because the market has been driven up by a handful of large-cap industrial multinationals supported by a weakening rand. He attributes the under-performance to the fund not owning many of these multinationals, the cost of hedging and the fact that some stock calls did not work out.


Momentum Capital Enhancer Fund

Unit trust fund classification: South African multi-asset medium-equity sub-category (complies with regulation 28 of the Pension Funds Act)

Targeted return: CPI plus four percentage points

Return over 10 years to June 30, 2016: 8.14 percent a year (inflation has averaged 6.18 percent over this period)

Rank in sub-category: 18th out 23 funds over 10 years to June 30, 2016

Average return for the sub-category: 9.08 percent a year over 10 years to June 30, 2016

Targeted risk protection: the fund aims to avoid losses over any rolling 12-month period

Risk target achieved: yes, over 10 years

Loftie Botha, the manager of the Momentum Capital Enhancer Fund, says the fund uses four strategies to ensure it achieves its risk-and-return target.

The first is the use of a strategic or static asset allocation and analysis of asset class returns over the past 30 years to pick the blend of up to eight asset classes that is likely to produce a return above the target at least 60 percent of the time.

The second strategy is the use of futures to vary the asset allocation at times to remove risk from the portfolio – this is known as tactical asset allocation, Botha says. He says this works well when markets are trending up or down. A third strategy is the adjustment of the asset allocation at certain times to remove risk from the portfolio.

Botha says the fourth strategy is to take out put options on the equity position in the portfolio. This costs between one and 1.5 percentage points of the return if you buy protection from two percent below the current market level, he says.


Who should invest?

Teichgreeber says the right time to use protected equity funds is when real (after-inflation) returns globally are low and it is difficult to earn positive returns. The late stage of a business cycle, when equities have had a good run and are expensive – as they are now – is a good time to invest in a protected fund, because you maintain your exposure to equities and the cost of taking out protection against a fall is quite low, he says.

Louw says someone who is three to five years from retirement, or who relies on an investment for a retirement income, should consider using Contego’s B5 Protected Equity Fund, because it offers the positive returns of equities at a fraction of the normal risk.

The Kagiso Equity Defender Fund is suitable for a living annuity investor, or any investor who, for whatever reason, is concerned about losing any of his or her capital over two to three years, Floor says.

Niehaus says the Old Mutual Dynamic Floor Fund is suitable for living annuity investors and investors saving for a specific goal.

Teichgreeber doesn’t believe it is possible to time the market cycle. “If you knew for sure what markets were doing, you could allocate 100 percent to equities, but we know it is impossible to do this, so it makes more sense to allocate across equities and derivatives, or different asset classes,” he says.

Many local investors are quite complacent, because there haven’t been any significant shocks to financial markets in the five years since the global financial crisis, he says. When investors become complacent, they feel they don’t need protection.


How do you judge a fund?

According to Teichgreeber, you should check that the fund you are considering has had no negative returns over the period the fund committed to achieving positive returns. He says Prescient’s Equity Defender Fund promises to capture as much of the positive returns as possible, but, in the event of markets falling, guarantees only that it will lose less than other funds in the same sub-category.

The Contego B5 Fund did have a negative return of about 1.2 percent in 2008, concedes Louw, but this was much less than the drawdowns of other funds.

Floor says you should look at the maximum drawdown of a fund, and its volatility level, when you choose a fund.

The Kagiso Equity Defender Fund wasn’t in its present form in 2008, but Floor says the European sovereign debt crisis of 2011, which caused equity markets to fall, and the period that followed the axing of Nene, are good periods on which to focus when you review the performance of a fund that uses hedging, to see whether it does what it claims to do: protect you against market losses.

Niehaus says you should determine what your risk-return needs are and then establish the following about a protected equity fund:

  • What is protected? For example, the fund protects investors against the Alsi falling by more than 10 percent.
  • How well has the strategy done in a market downturn, such as the one in 2008/9?
  • How long has the manager been managing funds using the relevant protected equity strategy?