Hedge funds: the long and the short of it

Hedge funds can add value to institutional investment strategies by reducing the dependence on traditional solutions and helping solve new investment challenges in an uncertain investment environment, says Bruce Simpson, CEO of Sanlam Alternatives, a division of Sanlam Investment Management (Pty) Ltd.

A lot of responsibility has been placed on trustees, not only to limit losses, but also to make sure that there is sufficient growth in members’ retirement fund portfolios. It is important, therefore in this environment of lower returns, to offer trustees alternative opportunities for sustainable risk-managed investment growth, at lower levels of volatility. Alternative investments (such as hedge funds) do precisely this. They offer pension funds the opportunity to potentially get equity-like returns but with less volatility. Says Simpson, while local pension funds are generally under-invested in these strategies, he recognises that globally institutional investors have started to become more open to these considerations as we enter a period of lower investment returns.

Alternative investments, by definition, use non-traditional approaches to investing. They typically offer investors a distinct set of attributes that are not commonly found in mainstream investment products. Alternative investments such as hedge funds use non-traditional investment strategies such as short selling, derivatives and leverage to maximise investor returns (irrespective of whether the markets are going up or down).

The tools of modern finance

Alternatives investments offer trustees and asset consultants the flexibility to invest widely across different sectors and asset classes, and to respond quickly to changes in the market, using tools that may not be available to traditional asset managers.

We often refer to these as ‘the tools of modern finance’. Non-traditional approaches to investing have enabled hedge fund managers to profit in both a bull and bear market, and to capitalise on mispricings between similar securities. Hedge funds are designed to reduce market volatility for investors by applying these specialist strategies and should be considered one of the building blocks of a well-diversified investment portfolio.

Derivatives are financial products that derive their value from any underlying set of assets, including equities or debt instruments. Short-selling is selling something you don’t own (have borrowed). The thinking behind this is that by the time you need to return it to the lender you would have been able to buy it for a cheaper price.  Leverage is using debt to benefit from market movements.

Volatile markets such as those currently being experienced present opportunities for hedge fund managers because they can profit in both up and down swings by going short the stocks they believe are overvalued, and long the stocks they regard as undervalued.

Using shorting and leverage can introduce some risk into a fund, but if used appropriately these tools can also be used to manage risk within a portfolio and to enhance returns.

Strategies in action: Relative value

A relative value hedge fund strategy is one that exploits differences in the price or rate of the same or similar securities. The relative value fund trades on gaps, rather than the price of a specific security alone. The relative value fund may take positions if the gap between prices or rates is considered to have reached its peak and is thus expected to shrink, or may take a position in a security if similar securities are experiencing price changes.

A relative fund manager will take long positions on securities considered undervalued, while taking short positions on securities considered overvalued. Fund managers determine what they consider normal differences in prices or rates by examining historical movements, and take positions that exploit gaps until the normal state is reached.

Using interest rate instruments

Says Johan Kurtz, Portfolio Manager for Sanlam’s range of fixed-income hedge fund portfolios, the typical levers we use are hedging, shorting and leverage to protect investors during turbulent times. We take specific views on (i) the level of the interest rate (ii) the slope of various yield curves (the fixed-rate bond curve, interest rate swap curve, forward rate agreements curve and inflation-linked bond curve)  (iii) the curvature (ie: are there dislocations along the yield curves that offer relative value opportunities?). Proprietary models then determine whether there are statistically significant relative value opportunities.

We take specific advantage of dislocations and anomalies along the term structure of interest rates (i.e. the yield curve). Here, leverage is used to combine mostly market neutral long and short positions between different interest rate instruments to express the relative value view. In other words, investors benefit from changes to interest rates and fixed income exposure. The idea is to hedge the risk of yield fluctuations and reduce the dependency of portfolio returns’ on cash returns (driven by interest rates and inflation). Most of our strategies are hedged and therefore less risky than typical long-only funds.

We aim to keep our fixed-interest hedge funds as liquid as possible and our returns are uncorrelated to other asset classes; we therefore don’t experience the same kind of drawdowns that one would experience in vanilla long-only funds during times of market turmoil. Furthermore, we run stop-losses on directional positions, enabling us to cut positions when the market proves a position to be wrong. For example, whereas the ALBI lost nearly 7% in December as a result of “Nenegate”, we were down only 0.8%.

Long-short strategies

Long/short equity is a fund management approach that involves combining both long positions (i.e. buying shares) and short positions (selling stocks you have borrowed) in order to make money. Says Greg Bergh, Portfolio Manager: Long Short Equities within Sanlam’s Alternatives team, the wonderful thing about financial assets, such as shares, is that you can reverse the order of events in order to make a profit. We all know about “buying low and selling high” but what if you could “sell high and then buy low”? That is exactly what we do in hedge funds.

By using this approach it may be possible to double the number of ways to make money. By being able to sell high and buy low, we can also make money out of falling markets because we have a significantly bigger toolbox.

Says Bergh, our approach is thematic in nature. We dig into the economic forces that are driving the world economy and the local factors that impact stocks. We look though our investment telescope and ask what will the economy look like 18 months from now?

What is going on with consumer confidence? (ie, should we be buying or selling retailers?) Are populations getting older or younger? (ie, should we be investing into hospitals or schools?) Will there be more electric cars on our roads in ten years’ time and will we even have our hands on the steering wheel? (ie, should we invest in companies who make automotive sensors and computer chips?)

We build up a set of themes and find companies that reflect our views with strong management and look for the weakest players vulnerable to poor conditions and build a portfolio of long and short stock positions. We combine this with an active trading approach that ensures we cut our losses quickly and this allows us the create a fund that gives a consistent return.

Multiple Strategy Hedge Funds

Sanlam’s multi-strategy hedge fund works across a combination of two main asset classes namely, fixed income and equities. The fixed income book is made up of instruments such as bonds, interest rate derivatives (e.g. swaps and FRAs) and currencies, while the equities book comprises stocks and equity derivatives. Uniquely, the two books (fixed income and equities) are managed in conjunction with each other. In other words, the managers aim to exploit opportunities in multiple asset classes while simultaneously targeting low correlations to the directionality of these asset classes.

Within each of the two books, there are different strategies such as direction strategies (betting on the asset either increasing or decreasing in value) and relative value/spreads/pairs strategies (playing two assets against each other). Other strategies include merger-arbitrage and a structured money market strategy.

The primary focus of the fund is diversification of exposures to manage and reduce risks, with the ultimate objective being smooth alpha generation and long term risk-adjusted returns. Risk management is key and drives the decision-making process. Strategic asset allocation is achieved through portfolio optimization techniques to maximise asset class diversification, while tactical asset allocation is utilised to ensure the fund is exposed to return-enhancing opportunity sets.

Conclusion

Alternative investments offer institutional investors a unique and distinct set of attributes not commonly found in mainstream investing. They have numerous benefits, particularly their low correlation to traditional investment products, their flexibility to maximise returns regardless of whether the markets are going up or down, their ability to manage risk, and significant diversification benefits. They use a flexible set of tools, which include derivatives, short-selling and leverage across a variety of asset classes, just like traditional asset management. Despite the similarities, alternatives investing offers retirement funds an important level of diversification that is unavailable to these investors in traditional asset classes, allowing  for the creation of retirement fund portfolios with superior return characteristics. We consistently maintain that giving pension fund trustees access to this broad set of innovative investment tools will ensure the protection and growth of the wealth of its members regardless of market movements.

Disclaimer

Sanlam Investment Management (Pty) Ltd (“SIM”) is an authorised Financial Services Provider. This publication is intended for information purposes only and the information in it does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Independent professional financial advice should always be sought before making an investment decision.