Are hedge funds unfairly maligned?
This article first appeared in the 1st quarter 2019 issue of Personal Finance magazine.
In the past year, hedge funds have been in the spotlight, for all the wrong reasons. Critics accuse them of failing to deliver on performance, while pocketing excessive fees. Is this really the case? And what is their role for investors?
Whenever I run into my friend Mike, an investment hobbyist, during the evening Woolies dash, the chat inevitably turns to the latest stock shocks. The minute I mention “hedge funds”, his eyes widen and, slightly breathless in awe, he asks if I’d heard about a certain fund manager who’d shorted this share and that, earning millions for the fund. And it’s this expectation of stellar performance, stacked against more muted returns, that may well have contributed to the spate of less favourable publicity.
What is a hedge fund anyway?
"Whenever I present workshops on hedge funds, I start by asking for a definition. And if there are 15 people in the group, you’ll get 15 different versions,” says Hayden Reinders, chair of the Association for Savings and Investment South Africa (Asisa) standing committee on hedge funds.
We talk about hedge funds as if they’re homogenous, but they’re not, says Bradley Anthony, managing director of Fairtree Asset Management. “With unit trusts, you’ve got money market, bond, equity, multi-asset, worldwide and global funds. In hedge fund land, it’s no different. You could have a hedge fund operating in equities, another in fixed income. There are so many different hedge fund strategies, each trying to achieve different outcomes for investors.” No wonder they defy easy definition.
Anthony suggests that the best way to think about a hedge fund is as an investment strategy with a broader toolkit than a unit trust fund. “The extra tools hedge fund managers deploy in markets include the ability to short, and to leverage.”
The investment strategy most of us are familiar with, whether we know the terminology or not, is taking a “long” position on a share in a company: buying it with the expectation that it will rise in value. When you take a “short” position, you expect the share to drop in price. You borrow the shares, sell them immediately, and if all goes as anticipated, buy them later at the lower price, give them back to the lender, and pocket the profit. If the shares don’t fall in price, you’ll lose money. (See “Shorting and leveraging explained”, below)
According to the 14th annual Novare survey, hedge funds represent less than one percent of the assets managed by our savings industry. Among the survey participants, these are the most common strategies:
Equity long/short (used by 60.4 percent of funds). They aim to reduce market risk by profiting from gains in their long positions, and from the declines in shorted stocks.
Fixed income (4.1 percent). Within the ambit of interest rates, yield curves, and government and corporate bonds, the fund manager looks for opportunities to profit from price discrepancies, using leverage to optimise returns.
Equity market neutral (12.4 percent). These funds take long and short positions in stocks in a similar sector, say Absa and Capitec, or Pick n Pay and Woolworths, depending on their view of the relative value.
Multi-strategy (7.9 percent) is a mix of strategies.
Let’s examine the facets of hedge funds that may have contributed to their dubious reputation.
The fees an asset fund manager charges are important. Even one percent, compounded over time, dents your return. Morningstar, a global investment research and management company, says its research shows that the expense ratio (proportion of fund assets used for administration, management, advertising) is the most proven predictor of future fund returns – the lower the fees, the better the returns. “That's not to say investors should use them in isolation,” adds Morningstar. “There are many other things to consider, but investors should make expense ratios their first or second screen.”
Anthony says the focus on fees is understandable. “The argument is that we need to compound from a higher base. If you invest R100 and R10 comes off in fees, if the fund manager produces 10 percent, you’ll get R99. You’re not even getting to the original amount, so it is very important to minimise fees.”
He believes that the conclusion that the lowest-cost investment product is best is faulty, though. “To my mind, the better strategy is to select the product that gives the most bang for your buck. You get what you pay for. If I go to a Michelin-star restaurant, I’ll probably enjoy their burger a bit more than one at the Spur. Am I going to criticise the Michelin-star restaurant for charging for it? In the investment world, if you’re happy to get what the market does, then great, find the cheapest index tracking fund – though it will always underperform the market because of costs! The other option is to go to an active fund manager and pay more because you want more than what the market delivers. If the manager produces it, are his fees too high? I’m more concerned about net return after fees relative to the stated objective of the fund, and each fund is different.”
Internationally, hedge funds tend to follow the “2 and 20” fee structure: a two-percent annual management fee and 20 percent performance fee. However, in South Africa, most funds charge a one-percent management fee with a 20 percent performance fee.
“The performance fee,” says Reinders, “only kicks in if the fund has performed well, usually on return above a benchmark (and sometimes a hurdle as well). And if your investment has gone up, do you as an investor care about higher costs? You care when the expenses are super high and the return is super low.”
And let’s not forget that there is a cost to the fund. In their survey, Novare pointed out that a hedge fund with assets under management of less than R50 million charging a one-percent annual fee takes R500 000 in fees. This needs to cover salaries, management company fees, research fees, regulatory capital, borrowing costs, marketing and more. Reinders says that he doesn’t see many Ferrari drivers among fund managers. “Hedge funds are cast in the mould of The Wolf of Wall Street, but I don’t think that reputation holds here.”
In reaction to emotive reports on hedge fund returns, Elmien Wagenaar, investment manager and director of Think.Capital Investment Management, reminds us that emotion can be detrimental to investment returns in the long term. She turns to hard data to interrogate performance (and risk).
By plotting the annualised risk and return figures over the five years from September 2013 to September 2018 on a graph, Wagenaar showed that funds within the Asisa South African equity general category are fairly tightly clustered, as are multi-asset high equity funds. On the other hand, the risk and return characteristics of hedge funds are highly diverse, which, she explains, shows clearly that no one hedge fund strategy represents hedge funds collectively. And even if you consider the characteristics of hedge funds within a general strategy – for example, equity long/short – there is vast dispersion there too.
The perception of performance of an equity hedge fund tends to ride on whether it under- or outperformed the market. But there’s more to the story: Anthony argues that it’s important to understand the stated objective of the fund. If a manager constructs a portfolio aiming to eliminate market risk (market-neutral), it’s inappropriate to measure their performance relative to the market. “These funds should have close to zero correlation to the market, so if the market goes up or down, the portfolio doesn’t necessarily go up or down in tandem.” And long/short funds can’t be compared with market-neutral funds. They produce different return profiles. “Long/short funds tend to have a low but positive correlation to the market, so they move with the market.”
When successful short-selling bids hit the headlines, we talk about it (or at least people like Mike and me do), etching it in memory. And if we remember something easily, we give it greater weight than what we remember less easily, and that hampers our ability to make considered decisions. (This mental shortcut, or “availability bias”, was proven by psychologists Daniel Kahneman and Amos Tversky.)
So when we hear instances of millions made in shorts, we extrapolate this to hedge fund performance in general, hence the unrealistic expectations. We are also guilty of focusing on more recent investment outcomes, rather than the longer view.
With the short-sighted tendencies of investors in mind, Wagenaar uses the top 10 return generating hedge funds over the past five years and contrasts their performance in the first three years with the latter two. The average return in the first part of the period contrasts starkly with the second, so investors who had come to expect robust returns may well have been disappointed, particularly if they’d entered a hedge fund in the past two years in the hope of more of the same. Investors who were in from the start, though, still enjoyed superior returns to equity and cash. But even over the past two years, hedge funds held their own: “A higher percentage of hedge funds posted positive returns than portfolios within the Asisa South African equity general category,” says Wagenaar.
Google “former head of the New York Stock Exchange” with “short selling” and you’ll find reports that he deemed the practice “icky”. Short sellers have often been blamed for failures in financial markets. But it’s a case of shooting the messenger; they don’t create the poor business models and balance sheets.
Johan Steyn, a Chartered Financial Analyst and investment management academic at Stellenbosch University, says short sellers play an important role in steering markets to higher efficiency by actively selling down a share where the market price is not reflecting poor quality fundamentals, and this aids in price discovery (ensuring a share is not under- or over-valued).
“I do see the problem with short sellers spreading propaganda to benefit their positions, but I don’t see it as a lasting problem,” he says. “If it is not backed up by facts, they lose credibility. So they can effectively only profit from a strategy based on deception once.”
Contrary to the general perception, many hedge funds have the potential to do well on managing risk, as measured by volatility. Wagenaar’s analysis underlines this. “At the same time as generating competitive returns, the right combination of hedge funds can do this at a fraction of the volatility of asset classes like bonds and equities,” she says. “This year has seen a great deal of volatility in equities. If you’re invested for the long term, you might not be too concerned about short-term dips in performance, but for investors who need to draw on their investments regularly, like those with living annuities, volatility becomes crucially important.” The risk involved in withdrawing money from a volatile portfolio – termed sequence of return risk – is lower when portfolio volatility is lower. Wagenaar believes that recent market experience has highlighted the value of the right combination of hedge funds in reducing this type of risk without compromising on longer-term growth.
Steyn also takes the view that hedge funds potentially offer investors risk reduction benefits. And, in times of heightened uncertainty, the ability to produce asymmetrical return distributions is especially valuable. “By virtue of the strategies and instruments they use, hedge funds should, in theory, offer better risk-adjusted returns relative to long-only funds. In down markets they should be able to offer better capital protection and in up markets, better participation due to the use of leverage. The uncorrelated nature of their returns relative to traditional asset classes also provides for diversification benefits.” He does add a rider, though: “The problem is that not all hedge funds deliver on the promise of these potential benefits.”
There’s some nuance to risk. If you’re conversant with the unit trust landscape, you’ll know that risk is largely linked to asset class: the risk in equities is higher than in fixed income, for example. Not so with hedge funds, cautions Anthony.
“Think of a tug of war between Arnold Schwarzenegger and me. Arnie is an equity unit trust, I am fixed income, and he outperforms me by a factor – let’s be complimentary to me and say it’s a factor of five. But in hedge funds, I can replicate myself five times using leverage, and potentially beat him. Leverage is a game changer. Because we are able to leverage and short in hedge funds, asset class risk does not dominate the risk profile. So when a retail investor says, ‘I want a low-risk investment, so I’d rather select a bond or fixed-income hedge fund than an equity hedge fund,’ it could be a big mistake. You need an adviser to tell you which hedge fund is aggressive, and which is conservative.”
Since 2015, hedge funds have been regulated under the Collective Investment Schemes Control Act (CISCA). Though the new regulations aim to contain risk, there’s an inherent acknowledgment that some investors have a greater capacity for risk than others. So under the new regulations, explains Reinders, there are two types: retail investor and qualified investor hedge funds. “In the latter, you need to understand what you’re getting yourself into – or appoint a financial services provider who does. The minimum investment by a qualified investor is R1 million, while retail minimums vary from fund to fund. And retail should have lower exposure to risk because you can’t leverage as much as you can in a qualified fund.”
The regulations demand accountability. “When you invest in a hedge fund, you’re getting an internally and externally monitored product,” says Reinders. “This is not a Bernie Madoff environment – you can’t be in another room shredding documents.” He reels off a list of third parties who monitor compliance and risk – auditors, administrators, risk assessors, and trustees. Also, all third-party stakeholders have to be pre-approved by the Financial Sector Conduct Authority (FSCA) and are routinely monitored for due diligence. He adds that most hedge funds use prime brokers, adding another layer of risk management. “Everybody’s watching everybody. That’s the benefit of regulation.”
Should you invest?
So hedge funds are well regulated, provide additional diversification and have the potential to reduce portfolio volatility. Should you invest?
“It’s important to have a qualified, reputable adviser!” says Anthony. (Personal Finance has you covered: search online for “What makes a good financial adviser” and “How to find a financial planner”.)
Certified financial planner and director at Crue Invest, Eric Jordaan, says it is important for your financial planner to understand why you want to invest, to assess your investment goal, and to help you determine the most appropriate investment vehicles – retirement funds, tax free investments, endowments, unit trusts – to achieve this.
“For the average investor, exposure to hedge funds is only achieved through the asset allocation decisions made by the fund managers of the investment funds that are selected as described above,” says Jordaan. “So a hedge fund is not a separate investment, but part of the asset allocation of your chosen strategy in pursuit of your goals.”
SHORTING AND LEVERAGING EXPLAINED
Bradley Anthony explains shorting thus: “Let’s say that in the smartphone market, I expect iPhone to outperform Samsung in price. So I buy an iPhone for R10 000. But if the iPhone price falls, I’ll lose money. So I want to cover myself – to hedge – against a loss. Because I think iPhone will outperform Samsung, I cover myself by shorting a Samsung. How do I do that? You are interested in buying a Samsung. I offer to get you one for the market price: R10 000. I find someone who has an extra Samsung and rent it for R500 for a year. I deliver the Samsung to you; you pay me R10 000.
“I now have a long position in an iPhone and a short position in a Samsung.
“Let’s assume my view is correct and smartphone prices fall, with Samsung falling further than iPhone. If Samsung has fallen by 10 percent, it’s now worth R9 000, and if the iPhone has fallen by 1 percent, it’s worth R9 900. I sell my iPhone, realising a loss of R100 because I paid R10 000. I then buy a Samsung for R9 000, gaining R1000 because I sold it to you a year ago for R10 000. Now I have a profit of R900. I settle the rental of R500, and give you back the Samsung. Through that trade, I made R400, a 4 percent profit.
“So even though the price of what I hold in my long position has fallen, I’ve profited from the relative performance.
“If I’m wrong, and prices rise in general, I still profit from the iPhone price rise, which hopefully offsets the loss on the Samsung.”
To illustrate the principle of leveraging, Anthony sketches two scenarios where property prices increase by 20 percent:
1. You buy a property for R1 million, and pay the full price in cash, without a bond. With the 20 percent increase in property prices, you have R1.2 million.
2. You buy a property for R10 million. But you only put down a deposit of R1 million, and take out a bond to finance the rest of the purchase price. When the price goes up by 20 percent, you sell the property for R12 million. Assume that what you paid to borrow from the bank (the interest) is R1 million. Your profit is R2 million, but after deducting the R1 million in interest, you’ve made R1 million net profit on your deposit of R1 million, which is 100 percent return. So, instead of a return of R200 000, by applying leverage, your return is R1 million.