Hedge Funds: Is SA playing second fiddle?

Reflections on the hedge fund industry from the recent ASSA Investments Conference.

At the recent ASSA conference in Sandton, a panel of leading hedge fund managers participated in a robust discussion of hedge funds and their long road to freedom.

Says Bruce Simpson of Sanlam Alternative Investments, “We will soon be approaching an historic milestone in the hedge fund industry: the twentieth anniversary of hedge funds in South Africa”. The very first formative hedge fund strategy was started around 1997 -1998, only gaining momentum in the early 2000’s. Today there are approximately 80 hedge funds in existence in South Africa, together employing over 120 asset strategies and managing around R65 billion in client assets. This is miniscule in the context of the broader investment industry. Says Simpson, we’re not in the business of aggressive asset gathering; it’s just not sustainable. In South Africa, the hedge fund industry is small, niche and collegiate. Everything moves quickly and is not overtraded; you have to stay small to remain agile.

Having said that, we’re on the cusp of a significant development – we expect an acceleration in the use of hedge fund strategies in years to come. From a regulatory perspective, it is currently easier for both retail and institutional (qualified investors) to access these hedge fund strategies. From an institutional investor’s perspective, the additional regulatory overlay from CISCA will definitely provide comfort and, as an industry, we are upbeat about the new regulation and prospects for the hedge fund industry.

How is the hedge fund industry currently positioned for allocators of capital in South Africa?
Says Simpson, this is currently a very exciting space for fiduciaries and other allocators of capital. There has been a lot of volatility in the equity environment – most recently BREXIT – and with it limited opportunity on the long-only side. However, with hedge funds you can take advantage of the full market cycle. Previously, if you’d been invested in equities you may have profited from being net long of the market, which worked well when markets were going up (but not while the markets were falling). The good news is that hedge fund managers can do well in both rising and falling markets. Performance is not exclusively reliant on markets going up.

What is the compelling rationale for institutional funds investing in hedge funds?
Primarily, it is the lack of correlation with other major asset classes, such as equities, bonds and property. For retirement funds, there is an opportunity to eke out better returns in an environment of lower returns too, when other asset classes are underperforming. See it simply as an additional arrow in the asset consultant’s quiver. Hedge funds offer diversification and a buffer in a very risky environment. They are a tactical allocation tool that can work well in both the short term and well as a longer-term strategy, as a diversifier. “However, we’re still seeing a lot of apathy from local institutional investors because they simply find the research too overwhelming and a valuable opportunity here is possibly being missed”, says Simpson. 

Are South African’s playing second fiddle to global investors?
In the global search for yield, the vast majority of the industry’s flows are derived offshore; this is because international investors have identified the South African hedge fund industry as a highly regulated and highly ethical industry, relatively efficient with new opportunities constantly emerging.

Have we missed a trick here?

If we assume there’s a cap on this industry’s size, it could be quickly eaten up by more astute international investors and we may find ourselves playing second fiddle, as we vie for secondary allocations into the hedge fund industry. It is intriguing that foreigners are climbing in while locals are running offshore; that locals are sceptics and foreigners are optimists. This is not only because foreigners have been exposed to hedge funds for longer than we have locally, but because the JSE has exceptional corporate managers, which we allocate amongst. Size is an issue though. From a scale percentage, the current size of R65 billion in assets under management is small, but you may reach capacity constraints when you get to R200-R250 billion, and you become limited in terms of the strategies you can execute.

What are the different tools in a hedge fund manager’s toolkit?
The three tools that hedge fund managers have at their disposal, which differentiate them from traditional products, are “short-selling”, “derivatives” and “leverage”. They might be long, they might be short or they might employ leverage, where appropriate. The key differentiator is choosing the right tool to select at the right time.

Hedge funds can hedge against downside risk by having significantly reduced exposure, being in cash or net short. These exposures can be reflected in the physical market or expressed using derivatives. In 2008 the equity market was down 23% but many hedge funds were up. Downside participation is therefore a key metric; as hedge fund managers, we believe that if we can limit downside risk significantly, then we’ve done our job. At the same time, we like to make it clear that our aim is not to replace equity exposure but to complement equity exposure in a portfolio.

Are fees justifiable?
Hedge fund fees are not as complicated as you might think. The interest of the investor and the hedge fund manager are very much aligned. Hedge funds charge a management fee and a performance fee like in the traditional space, however performance fees are levied relative to cash and not relative to a benchmark. Hedge funds in general earn their fees beyond a certain hurdle rate.

Hedge funds, as alternate forms of investment categories, are considered historically expensive but offer a new element of real return. In the traditional space, it’s not as easy to achieve those returns, so investors are more willing to pay a small premium for the outperformance generated. Management fees are important to keep the business alive and pay the bills; as alpha seekers, we have to have the performance incentive built in.

We believe the tide is turning, buoyed by CISCA’s regulatory wave and environment of lower returns, says Simpson. Regulation 28 changed in 2011 and now, more recently, CISCA recognises that hedge funds have a rightful place within the pension fund space. Hedge funds are not necessarily risky. They aren’t complicated. They aren’t run by cowboys. Hedge funds merely offer institutional investors the flexibility to invest through the market cycles, as an additional arrow in the fiduciary’s quiver.