Hedging your bets
Hedge funds are a good way to diversify your risk, writes Johann Barnard
An investment portfolio’s ability to produce above-market returns is always due to a combination of factors. For advocates of hedge funds, the promise is generally for returns counter to market conditions.
This is obviously a simplification of complex strategies that fund managers employ to deliver returns based on their convictions about different sectors, asset classes and individual counters. Their big selling point, however, is the promise of superior returns compared to the rest of the market.
This promise does come with an important caveat — particularly for investors who could be classified as retail. And that is that hedge funds certainly offer a proven method of risk diversification, which should always be employed within the context of a broader portfolio of other diverse assets.
"The only free lunch in investing is diversification," says Peter Urbani, of Sanlam’s hedge fund business, Blue Ink Investments. "Where they come into their own is as an alternative source of alpha. However you view what they’re doing, in an ideal world they provide you with a diversification benefit."
He cites the 2008 financial crisis that sparked a 50% collapse of equity markets, whereas hedge funds were down by an almost-palatable 20%. The relative performance of hedge funds in extreme crises is often given as justification for their existence.
But figures provided by Urbani for Blue Ink’s composite hedge fund index over the past three years to end-April show that a hedge fund doesn’t need a crisis to outperform. The index shows that, on average, SA hedge funds produced compound annual growth of 8.73% compared to the FTSE/JSE all share index of 6.32%, and the 4.3% of the Asisa SA EQ general benchmark.
Blue Ink’s returns, however, belie the challenging conditions that hedge fund managers have been experiencing.
Alexia Kobusch, MD of Nautilus, says she is concerned about how fund managers are going to make their returns.
"The market has been tough for portfolio managers this year. Market volatility has been muted, which means the ability to make short-term gains has been challenging. Because of the political uncertainty locally and abroad, the market hasn’t really been trading on fundamentals either," she says.
"Some guys are getting it right, but because of the muted volatility this is not in any way different from a long-only manager," Kobusch adds. "So the problem is that even though you have the ability to go short, if the market isn’t moving at all, it’s irrelevant."
Urbani argues, in contrast to this view, that there is a high dispersion of returns in the equity long-short space, depending on the skills of the fund managers.
"But when you look at the range of that dispersion compared to long-only equity managers, the worst of the hedge funds are still significantly better than even the bottom quarter of the general equities. And the best are much higher."
He does concede that some funds may underperform over shorter periods, but says the advantage hedge funds have is the ability to provide asymmetric returns compared to long-only investments.
Kim Hubner of Laurium Capital shares the views of Urbani and Kobusch regarding the vagaries of current market conditions and the variable performance of local hedge funds.
Last year was "a very difficult year for many hedge funds due to the impact of unpredictable macro factors.
"It’s about how you manage your risk. Macro factors are difficult to predict, but you have to have a view regardless. However, most of what we do is bottom-up stock-picking, and that is where we spend most of our time. In addition to this, we look for special situations and trading opportunities that can add additional alpha.
"Over the long term, hedge funds have done what they set out to do in terms of protecting capital and giving clients decent returns," Hubner says.
According to Laurium, over a 10-year period, from January 1 2007 to December 31 2016, long-short equity funds (peer group average as measured by HedgeNews Africa) had an annualised return of 10.8% after fees, comfortably beating the average SA General Equity Fund and SA Multi-Asset High Equity Fund, which returned 8.8% and 8.6% respectively. The FTSE/JSE all share (TR) over the same period had an annualised return of 10.4%.
Over the financial crisis (August 1 2008 to February 28 2009), the FTSE/JSE all share (TR) had a maximum drawdown of -32%, compared to the average SA General Equity Fund of -26%, and average SA Multi-Asset High Equity Fund max drawdown of -11%. The average long-short fund over this same time only had a maximum drawdown of -9%.
The good news for investors is that these benefits and returns are now easily accessible through the retail hedge funds that have been registered with the Financial Services Board. How appropriate these are and the exposure one wants should obviously be decided in consultation with an investment professional.