Despite the misconception that hedge funds are risky investments, South African-based funds are in fact relatively conservative. Interestingly, many South African investors still perceive hedge funds as the riskier investment when compared to other more traditional and more familiar investment vehicles/ strategies. 

According to the Alternative Investment Management Association (AIMA), proof points that contradict common hedge funds myths are often overlooked due to the historic nature of hedge funds keeping a low profile and gaining publicity on the odd occasion when a blow-up or fraud case causes news headlines.

Here are some of the common misconceptions surrounding hedge funds.

Myth: Hedge funds aren’t regulated and the industry is secretive and mysterious

Hedge fund specific regulation may have only come into effect recently, however, hedge fund asset managers have been regulated under the Financial Advisory and Intermediary Services Act (FAIS) since October 2007 under a separate license category, CATIIA. (Discretionary asset managers such as unit trust asset managers require a CATII licence.)

In 2015, Hedge funds were included under the regulation of the local Collective Investment Schemes Control Act also known as CISCA. Under the new regulation, hedge funds will be more accessible to a broader investor base.

Most hedge funds in South Africa operate as collective investments, hence the decision for hedge fund regulation to be in line with existing collective investment regulation. To address the regulation of the hedge fund product, the Financial Service Board (FSB) together with National Treasury and industry players embarked on a consultative process to understand the South African hedge fund landscape and compile suitable regulation, which saw hedge funds being regulated under CISCA. CISCA also regulates the well-known unit trust industry.

Myth: Hedge funds are risky investments

Although hedge funds invest in the same asset classes as traditional unit trust funds, the difference is that it can take advantage of a wide range of investment tools and thereby generate other sources of return. Hedge funds tend to have low correlations to traditional portfolios of stocks and bonds, therefore, allocating an exposure to hedge funds can be a good diversifier.

Contrary to popular belief, this strategy aims to achieve positive returns at a reduced level of risk. Characteristics making hedge funds unique includes the use of derivatives, short selling, leveraging etc. to be able to extract positive performance in both upward or downward trending financial markets.

One of the main objectives of the regulation by National Treasury is the monitoring and measuring of systemic risk while enhancing product requirements to protect investor interest.

Myth: Hedge Funds charge high fees

According to the 2016 Novare Hedge Fund Survey results, a decrease in annual management fees has been seen, combined with funds employing a higher hurdle rate for performance fees. Fees have always remained topical and the hedge fund industry has not been exempt. For the first time, under the new regulation, retail hedge funds will have to disclose their Total Expense Ratio (TER) to the public. More than two-thirds (66.3%) of the funds charge an annual management fee of 1.0%, up from 58.1% the previous period, this has been as a result of those charging higher fees decreasing their rates.

The local hedge fund industry does not follow the typical 2.0% Annual Management Fee (AMF) and 20.0% performance fee ratio. Instead, a 1.0% AMF and 20.0% performance fee ratio is the popular charge. More than two-thirds (66.3%) of the funds charge an annual management fee of 1.0%, up from 62.0% the previous period.

A migration to lower charges has been observed, with those charging 1.5% decreasing from 23.9% to 15.3%, this has been driven by two main asset managers who previously had that fee structure.

Myth: Hedge funds produce big swings in performance

As with any investment, time is your best friend and market movements and subsequent volatility will continue to have an effect on investments, no matter the strategy. Hedge fund managers take calculated risk as would any fund manager. But, the extent of the draw-down in negative markets is less and therefore, the recovery is quicker.

The advantages of hedge fund managers having more investment tools at their disposal is that they can take advantage of both rising and falling markets and profit from rising or falling financial markets, thereby providing capital protection. 

According to the survey, the industry has experienced uninterrupted and tremendous growth in assets of 118.3% over the past five years. Solid performance remained the main driver of asset growth as investors were seen rewarding managers that had good returns by increasing their allocation – a reflection of the growth and stability of local hedge funds when it comes to size. 

Myth: Hedge funds are only for the rich or big corporates

Under the new regulation, hedge funds will be more accessible to a broader investor base and have been classified into two categories- retail investor funds (RIHF) which have more stringent regulation requirements, and qualified investor hedge funds (QIHF). Retail hedge funds are available to the general public, whereas it is only qualified hedge funds that are suited to the savvy investor and corporate investor.

A Qualified investor, as defined by the FSB Board Notice 52 of 2015, is: any person who invests a minimum amount of R1 million per hedge fund and who – (a) has demonstrable knowledge and experience in financial and business matters which would enable the investor to assess the merits and risks of a hedge fund; or (b) has appointed a Financial Services Provider (FSP) who has demonstrable knowledge and experience to advise the investor regarding the merits and risks of a hedge fund investment.

A retail investor hedge fund is defined as a hedge fund in which any investor may invest because it meets the requirements set out by the FSB.

The idea that hedge funds are not inclusive is also countered by the fact that from 2011, investors could allocate up to 10% of their contributions to hedge funds after the Regulation 28 of the Pension Funds Act (Act 24 of 1956) was amended to include this hedge fund exposure limit.

Myth: Hedge Funds make use of exotic assets and investment strategies that aren’t well known

Hedge fund invest in the same securities as unit trusts, the difference is that it has more ways of protecting assets and delivering positive returns irrespective of market direction.

Take a unit trust for example. The underlying assets in a unit trustfund are made up of cash or money market instruments, shares, gold bullion, listed property, listed offshore shares, local government bonds and some use of equity derivative products are used to protect the downside.

Hedge fundsare made up of the same assets but have a wide range of tools available to use in order to optimise these assets, such as derivatives, short selling, leveraging etc.

Strategies that hedge fund managers in South Africa typically make use of include:

• Equity long/short:Funds aim to generate positive returns by being simultaneously long and short in the equity market.
• Equity market neutral:Funds take similar sized long and short positions in related equitysectors with the effect that directional market risk is offset.
• Fixed income arbitrage:An investment strategy that attempts to profit from arbitrageopportunities in interest rate securities.
• Statistical arbitrage:Quantitative models are used to identify market opportunitiesand establish short-term positions involving a large number ofsecurities.
• Volatility arbitrage:Funds aim to take advantage of mispricing between similar instruments
• Multi-strategy:An investment philosophy allocating investment capital to a variety of investment strategies and potentially across several asset classes.
• Commodities: Funds that predominantly invest in soft commodities.

Myth: Hedge funds are managed by fly-by-night managers

According to the 2016 Novare Hedge Fund Survey findings, 73.2% of industry assets are managed by hedge fund asset managers with experience in hedge funds exceeding eight years. It should be highlighted, that in addition to the aforementioned eight (and more) years of hedge fund specific experience, this does not take into account the years spent in the financial services industry working with traditional funds, prior to their move into the hedge fund-specific investment space. Hedge fund managers have an immense understanding and vast years of experience within the financial services industry.

Myth: Hedge funds are managed by small and unknown boutique asset managers

Although the perception may be that hedge funds are managed by niche, boutique investment houses, the reality is that hedge funds form part of most of South Africa’s largest financial service provider’s offering. Hedge funds’ assets are not the only assets managed by hedge fund managers, and most form part of a well-diversified asset management business managing a multitude of investment offerings.

According to the survey, the lion share of assets are still being managed by asset managers that manage total assets exceeding R2 billion (translating into 85.7% of hedge fund assets being managed by these asset managers). Similar to the findings of previous years, the bulk of hedge fund assets are managed by asset managers that manage between R10 million and R100 billion (38.5% of hedge fund assets).

We are seeing asset managers maturing and hedge fund businesses becoming more mainstream. Managers have raised business assets and have diversified their income stream by adding other product offerings. We now see a healthy business mix that is robust, alleviating some of the business concentration risks.

In conclusion, the South African hedge fund industry is ever more transparent and accessible to retail investors with increased oversight and regulation from the FSB. The new regulation is a step in the right direction, and yet another confirmation that this industry is here to stay. The industry has grown in leaps and bounds over the years, with operational sophistication and efficiency being at the forefront.