Are we missing out on hedge fund diversification?
Long-term returns that could prove their case are still lacking, and managers are highlighting shorter-term performance
Local hedge funds have slowly been cleaning up their act to be more appealing to ordinary investors. But they still have a way to go before financial advisers and investment platforms make them readily accessible. Hedge fund managers believe we are missing out on potentially better returns that diversifying into this alternative asset class could offer.
Long-term returns that could prove their case are still lacking and hedge fund managers are highlighting shorter-term returns. Fairtree’s equity portfolio manager, Cornelius Zeeman, says that on average SA hedge funds have outperformed 157 of the general equity unit trust funds in the past 12 months.
Zeeman says the average return of hedge funds for the year ending September 30 was 4.26% compared with the all share index’s -1.46%. He says a significantly higher percentage of hedge funds than unit trust funds outperformed cash and the all share index over the past year too.
Among the hedge funds that can be sold to retail investors, 82% outperformed the JSE all share over the past two years, while only 45% of long-only funds achieved the same feat, Zeeman says.
Hedge funds have a much lower correlation to the JSE all share than traditional long-only equity funds and should be considered as an alternative way to hedge against SA’s challenging investment environment instead of betting all on offshore investments, he says.
Regulation introduced in September 2015 required all new hedge funds from that date to register as collective investment schemes. Existing ones had until April 2017 to convert to collective investment schemes. Most of the funds that are now collective investments, including those suitable for ordinary investors (retail hedge funds) have just a three-year history as collective investments but are not reporting it to data providers such as Morningstar or ProfileData, which makes it difficult to compare funds and compare them with other similar unit trust funds.
Recently, however, the Association for Savings & Investment SA (Asisa) announced that a new hedge fund classification standard will come into effect on January 1 2020.
Hayden Reinders, head of alternative fund administration at Prescient Fund Services and chair of the Asisa standing committee on hedge funds, says Asisa hopes the new categories will lead to more funds reporting their returns to data providers.
When longer-term comparable returns become available, Wilhelm Landman, a director at AIP Capital Management, which manages various retail hedge funds, says investors will see that hedge funds, like other funds, have varied performance.
He says that over short terms equity long-short hedge funds slightly outperformed the JSE on a total return basis. Fixed-income hedge funds enormously outperformed bond indices and traditional bond funds. Multi-strategy hedge funds have significantly outperformed balanced funds.
These returns were typically achieved with a lower market risk exposure and volatility than traditional funds, he says.
As evidence of this the retail equity hedge fund managed by 36One, for example, returned 8.86% on average a year for the past three years since it became a retail investor hedge, relative to the all share index’s 7.06% return.
And Fairtree’s retail fixed-income hedge fund, the Proton RCIS Retail Hedge Fund, returned 31.54% on average for the three years to end-October, outperforming the all bond index by an average of 3.6 percentage points a year.
Hedge funds shouldn’t be seen as a substitute for any of the traditional asset classes but rather as a complementary component that enhances risk and returns, Landman says.
If investors compared their portfolio since late 2016 with exactly that same portfolio but with 10% allocated to a basket of divergent strategy hedge funds, they’d probably find that their returns were enhanced and their portfolio suffered smaller drawdowns through the period, he says.
But even with longer-term performance data, there are obstacles to investors accessing hedge funds. Most investors use financial advisers and/or investment platforms to invest.
Hedge funds are no longer the maverick investment products they once were; they’re simply a different asset class that should be available to allAIP Capital Management' director Wilhelm Landman
While retirement funds are allowed to invest up to 10% in alternatives that include hedge funds, unit trust funds that are not themselves hedge fund of funds cannot yet invest in hedge funds. And few hedge funds have been added to investment platforms.
Landman says most investment platforms have listed fund of hedge funds, but few single-manager hedge funds have been included so far. This prevents discretionary fund managers from including hedge funds in the portfolios they construct for financial advisers.
Eugene Visagie, portfolio specialist at Morningstar, says most platforms can only accommodate funds that do daily and not monthly pricing. As more funds adopt daily pricing, more will find their way on to platforms.
Reinders says some funds price a day late rather than the same day and this is a problem for some platforms.
Visagie says platforms also want to know that investments will flow into funds before they list them.
Regarding advisers Landman says many don’t recommend hedge funds because they are not licensed to do so and don’t have experience working with these funds.
Many of them also use multi-asset fund of funds for their clients, and these funds cannot invest in hedge funds.
Reinders says wide-ranging draft revisions to board notice 90 under the Collective Investment Schemes Control Act that enable unit trust funds to invest in hedge funds are expected to be published in the first or second quarter next year.
Visagie says the role of discretionary investment managers or multimanagers is crucial in blending hedge funds into a portfolio to reduce volatility and increase returns, as investors need their expertise to understand the hedge funds’ diverse strategies.
Morningstar’s discretionary fund manager will consider hedge funds when they are available on platforms as they do provide an alternative source of returns above the market, Visagie says.
Landman believes that investors need the additional diversification that hedge funds can offer in this low-return environment. “Hedge funds are no longer the maverick investment products they once were; they’re simply a different asset class that should be available to everyone,” Landman says.
Another reason investors and their advisers steer clear of hedge funds is their high fees. Hedge funds have traditionally charged a high 2% annual fee with a hefty 20% performance fee on returns above what are often low hurdles such as the return on cash.
But fees are falling, with the latest Novare survey of hedge funds showing that 60% of funds are now charging a 1% annual fee with the 20% performance fee. About 10% of managers have dropped their 20% performance fee to 15%, the survey shows.
At the moment, however, they are still the preserve of the wealthy who have discretionary money to invest, Visagie says.
SA hedge fund lingo
Hedge funds aim for positive returns even when markets are falling. They do this by using a wider range of investment instruments than regular funds, including derivatives (instruments that derive their value from other securities), short selling (selling a security you expect will lose value), leveraging or borrowing.
SA hedge funds are now collective investment schemes — some with more restricted access while those that are available to ordinary investors must comply with certain strict criteria.
Fairtree’s Cornelius Zeeman says retail hedge funds look and feel like a traditional unit trust as they have daily pricing, daily liquidity and low minimum investment thresholds (R50,000). They limit their borrowing (or gearing) to two times, which is low considering that most people buy their homes with 10 times gearing, he says.
Retail hedge funds may not invest in volatile asset classes such as soft commodities (for example coffee, cocoa, sugar, maize, wheat, soya beans, fruit or livestock), he says.
Qualified investor hedge funds are for investors with more than R1m to invest, who can demonstrate that they have sufficient expertise to understand the risks or who invest through a financial adviser with that expertise.
The Association for Savings and Investment’s new hedge fund classification standard, which comes in next year, will define whether a hedge fund is South African (at least 60% invested in SA markets), global (at least 80% invested in markets other than SA), worldwide (no limits on either domestic or foreign assets) or regional (at least 80% invested in markets in a specific country or region).
It will classify hedge funds in line with the assets in which they invest: equity, fixed income, multi-asset or other.
It will attempt to define the strategy in terms of whether funds are those with a long-bias equity funds as they aim for an equity exposure in excess of 25% of the fund or whether they are market neutral — with between -25% and 25% equity exposure or have some sector-specific exposure.