The long and the short of hedge fund investment strategies

By Supplied Time of article published Nov 23, 2021

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By Andrew Ludwig

The mere mention of the term “hedge funds” used to have many investors running for the hills, usually for the wrong reason. Today, these strategies are better understood and the industry more regulated, with hedge funds governed by the Collective Investment Schemes Control Act (CISCA), enabling managers to offer investors real portfolio diversification without compromising their real return objectives. We recently interviewed the fund managers at Blue Quadrant and 36One Asset Management to discuss their long-short hedge strategies and how investors can benefit by including them in their portfolios.

The most common hedge fund strategy is a long-short hedge strategy, representing two thirds of the industry. A long-short equity strategy seeks to minimise market exposure while profiting from stock gains in the long positions, along with price declines in the short positions. Long and short are not a measure of time, but of the perceived direction of the investment profiting.

There is a popular misconception that hedge funds should always do well during market declines and that the only reason to invest in a hedge fund is to obtain some form of “insurance” against a market decline within the context of a broader portfolio. The hedge fund industry is, however, very heterogeneous and there are many different types of strategies that can deliver returns at various points in any market cycle, not specifically during a bear market.

“In our view, hedge funds have the ability, given their generally flexible mandate, to offer real portfolio diversification without compromising an investor’s real return objectives. Although our volatility profile is similar to most long-only equity portfolios, our return profile has been uncorrelated over time with most passive or benchmark-driven funds. In terms of risk, although our historic volatility is higher than average, we feel that our fund has a lower than average risk, taking into consideration that we typically run a very small short book, do not engage in complex derivative structures and even when accounting for our exposure to other asset classes, such as commodities and currencies, our leverage typically fluctuates between 1x and 1.5x NAV,” said Leandro Gastaldi, portfolio manager at Blue Quadrant.

“We believe funds that have a high percentage of what you could define as “permanent capital”, such as the fund manager or fund management company’s (or shareholders) own money being invested in the fund, offers outside investors an advantage. Very often when a fund manager is forced to incur a permanent capital loss on an investment, it happens during a drawdown and when investors start to redeem, they force the manager to liquidate prospective investments at the bottom of the cycle. Around 80% of our fund’s assets are sourced from our shareholders or a related party to one or more of our shareholders” adds Gastaldi.

Gastaldi stresses that investors must understand the type of risk inherent in a fund’s chosen strategy. “Although there are not many examples, high profile ‘blow ups’ such as Long-Term Capital Management in 1998, which painted hedge funds as risky or riskier, even though this is not the case for most funds. Investors, even institutional investors, often have a myopic focus on volatility as an absolute measure of risk. There are other factors to consider, such as does the fund employ complex derivative strategies which may have an overreliance on historic data correlations, or what level of leverage does the fund employ? Many ‘low volatility’ or arbitrage strategies often blow up as a result of excessive leverage and overconfidence in historic volatility data or patterns,” he adds.

Steven Hurwitz, an investment analyst at 36One, believes that not all hedge funds are created equal. He offers several reasons why the strategies below give hedge funds the ability to reduce volatility in a portfolio, especially in comparison to the market and other equity-like instruments.

Hedge funds have the ability to short, giving managers a broader opportunity set and the ability to take advantage of declines in stock prices.

Not only can these strategies generate profits from their long and short positions, but the short positions act to reduce market exposure. This also provides an element of protection (or hedge) when markets decline, because the gains on short positions will offset the losses on long positions.

Managers can adjust their gross and net exposure in response to changing market conditions, thus helping protect capital.

Low correlation to the market improves your risk return profile.

“Accessing hedge funds in the past was difficult, which created resistance. Today, with more regulation and oversight, retail hedge funds look and feel like a traditional long-only portfolio, with lower investment minimums, daily pricing and daily liquidity. Investors and advisers can now easily access hedge funds directly from the manager or via various Lisp platforms,” says Hurwitz.

Hurwitz believes that South African hedge funds are suitable for all types of investors. “Maximising returns for a given level of risk is the ultimate objective for all investors,” he says. “Investors who rely on their funds to provide a monthly income, such as living annuitants, are ideally suited for hedge funds. Large drawdowns can negatively impact clients with living annuities, as there is less capital available when markets recover. Many hedge funds do a great job of protecting capital and reducing the severity of drawdowns, thereby protecting the longevity of a living annuity portfolio.”

“Hedge funds should also be considered in the pre-retirement space, for investors still accumulating wealth. Depending on the hedge fund’s strategy, the fund can provide exposure to growth assets (like equities), with significantly lower risk. Pre-retirement investors will need to consider Regulation 28 limits (the current limit is a 10% allocation to hedge funds and 2.5% per single hedge fund manager),” concludes Hurwitz.

Andrew Ludwig is the owner of Fund Hub, an independent investment platform showcasing South Africa’s top asset managers.

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