Financial consumers back hedge funds for better risk-adjusted returns, downside protection

The SA hedge funds industry is gaining popularity among a broader range of consumers due to increased regulatory oversight

Hedge funds, once the preserve of high net worth (HNW) individuals and institutional investors, are gaining favour across a broader cross section of the consumer market thanks, in part, to greater regulatory oversight. Local consumers are pouring billions of rands into this asset class for its dual benefits of downside protection from financial market contagion and consistent long-term returns.

Figures from the Association for Savings and Investment South Africa (ASISA) illustrate the popularity of the asset class, with total assets under management (AUM) in the hedge fund sector topping R137.9 billion by the end of December 2023. The sector attractaced a record R6.24 billion in investment inflows in 2023 (2022 R4.54 billion) as the domestic hedge fund universe grew to 213 funds, managed by 11 licensed fund managers.

“The latest 12-month cash flows indicate hedge funds are being accepted as an important investment tool in mitigating financial market volatility,” says Hayden Reinders, convenor of the ASISA Hedge Funds Standing Committee. He welcomes the stronger uptake of hedge funds, especially among retail investors.

South Africa’s financial consumers may be familiar with unit trust funds, today called Collective Investment Schemes (CIS) portfolios — which appeared on the local investment scene in June 1965 — and have since grown to R3.498 trillion in AUM across 1 832 local portfolios. Hedge funds have some way to go to catch up.

“A hedge fund is similar to a unit trust fund but has broader discretion in terms of the types of investments the fund manager can pursue, and the set of tools that can be employed by the manager to generate returns and manage risk,” says Alan Yates, Head of Distribution at Peregrine Capital. He notes that hedge fund managers can invest in the same asset classes available to traditional unit trust managers, but unlike with unit trusts, they can extract positive performance in both upward- and downward-trending markets.

Hedge funds struggled to gain acceptance locally between their introduction in the mid-to-late 1990s and 2015, when the asset class finally caught the financial conduct regulator’s attention. “In 2015, new regulations allowed for hedge funds to fall under the country’s Collective Investments Schemes Control Act (CISCA) and be formally registered as CIS portfolios with the Financial Services Conduct Authority (FSCA),” says Kim Zietsman, Head of Business Development at Laurium Capital.

South Africa was among the first countries to implement comprehensive regulations for hedge fund products, creating a strong “pull” for investors’ capital. Amendments to regulation 28 of the Pension Funds Act, effective from January 2023, have helped too. These amendments differentiate between hedge funds and private equity investments, allowing retirement funds to allocate up to 10% of members’ capital to the former asset class.

The 2015 regulations also opened the market to individual (or retail) consumers by creating two regulated hedge fund structures. The first, suitable for HNW individuals and institutional investors, is referred to as a Qualified Investor (QI) fund, which has a regulatory minimum investment size of R1 million per investor, and has a wider allowable range for measures such as gross exposure, position concentration and leverage.

The second, called the Retail Investor (RI) fund, has no regulatory minimum investment size and is therefore more widely available to the lay investor. “Retail funds have stricter limitations on maximum levels of gross exposure and position concentration, among other features, to give retail investors more comfort around the risk management framework of the investment,” says Yates.

His observations are seconded by Emma Pretorius, Investor Relations at Amplify Investment Partners. “Retail hedge funds are more strictly regulated by the FSCA in order to protect investors; the regulator has put in place limits on the amount of leverage that these managers can use, resulting in strategies that are generally less risky than their qualified counterparts,” she says.

So, how do hedge funds work? ASISA reports on the local hedge fund industry under four fund types including SA Long Short Equity; SA Fixed Income; SA Multi-Strategy and SA Other. Around a third of the sector’s assets are held in RI (responsible investment) funds, which have become more accessible to retail investors due to the aforementioned regulatory actions and the fact that more investment platforms now offer them.

Long Short Equity funds are portfolios that predominantly generate their returns by pairing long positions on equities with short selling to benefit from both rises and drops in market prices. Although Long Short Equity dominates the rankings by AUM, the SA Multi-Strategy funds have proved popular among both retail and qualified investors measured by net fund flows in 2023.

“Multi-strategy hedge funds are portfolios that do not rely on a single asset class to generate investment opportunities, but instead blend various strategies and asset classes, with no single asset class dominating over time,” Reinders says. Regardless of the overarching hedge fund strategy, the challenge facing fund managers is to leverage the unique tools at their disposal to maximise the risk-return balance to investors.

The ability to engage in short selling — whereby one profits from a decline in share prices — is arguably the most popular tool. “Most unit trusts strive to outperform a benchmark, whereas hedge funds can focus on generating absolute returns, delivering positive returns to clients irrespective of how the broader market performs,” Yates says. The ability to “short” a share opens the door to a range of investment strategies. 

“Hedge funds receive cash in return for the shares they sell short, and can deploy this cash to buy stocks that they expect to rise in value, a mechanism called leverage; traditional unit trust managers cannot do this,” says Busi Ngqondoyi, Old Mutual Multi-Manager’s Head of Hedge Funds. She notes that hedge fund managers can also use derivatives such as futures and options contracts, though this is for the purpose of efficient portfolio management rather than to enhance returns.

Fund managers use words and phrases like diversification, low correlation, return drivers and volatility reduction to explain the benefits in hedge funds. “These funds have the ability to generate uncorrelated returns for investors,” Yates says. The flexible investment strategies that hedge funds employ — including derivatives, leverage and long-short positions — mean they are not overly-dependent on a rising market to generate returns.

Commenting on volatility reduction, Yates notes that hedge funds “can protect investor capital by not participating fully in market drawdowns”. Put differently, these funds allow investors, guided by their financial advisers, to implement protection against falling markets; reduce market or sector exposure; and offer another point of return generation. 

“Hedge funds should technically be able to outperform all types of markets, but they usually excel when there is a spike in volatility,” says Henko Haasbroek, Client Director at Ninety One. In his view, common benefits of hedge funds include better risk-adjusted returns; downside protection; and lower volatility. These funds also offer bi-directional returns in that they can make money whether the market goes up or down.

Pretorius offers a slightly different benefits explainer, noting that hedge funds generally employ either return-enhancing or risk-mitigating strategies. “Return enhancers generally are more correlated to markets and have greater exposure to the market; while these funds should give you returns in excess of the market, they will not materially reduce the risk in your portfolio,” she says.

In contrast, risk mitigating strategies are generally uncorrelated to market indices and consequently offer reduced portfolio volatility, drawdowns and (in some cases) increased compounded returns. “There is a place for both strategies in investor portfolios, but it is important that investors have a clear idea of what they are aiming to achieve when selecting hedge fund strategies to invest in,” Pretorius says. 

The caveat is for retail investors to seek assistance from their financial advisers before simply piling into a broad cross section of hedge fund strategies and types. 

“Investment tools like derivatives, leveraging and short selling allow hedge fund managers to extract positive performance in upward trending markets and protect investors’ capital during downward trending markets,” says Zietsman, adding that low correlations to traditional CIS funds make hedge funds a good portfolio diversifier.

Zietsman also offers two reasons why hedge fund managers enjoy a high degree of flexibility in managing investors’ capital: first, thanks to the strategies and tools they employ, and second due to the relatively smaller size of hedge funds. “Smaller funds have the ability to be nimble, react faster to information and take more meaningful positions in mid-and small-cap stocks,” she says.

There are some drawbacks to hedge funds that investors should keep in mind. “While hedge funds offer compelling benefits on a net of fees basis, the fees charged can be a bit high for many investors,” Ngqondoyi says. “This is particularly so following periods where hedge funds have delivered strong performance relative to other asset classes and therefore charge performance fees.” 

Fees have come down significantly over the years, and there is also wider acceptance of focusing on the net of fees outcome. Zietsman recommends investors avoid looking at fees in isolation and rather gauge the level of cost in relation to the expected value that the investment might add.

“The higher fees charged by hedge funds relative to traditional unit trusts are often cited as a reason not to use them, to the point where the risk-adjusted returns after fees are not even considered; fees matter, but you cannot lose sight of the goal of improving risk-adjusted returns,” she says. 

It is now easier to access hedge funds than ever. “Most hedge funds can be accessed directly; but recently, many hedge funds have become available on popular Linked Investment Service Provider (LISP) platforms,” says Haasbroek. He says hedge funds are for everyone, and believes the domestic hedge fund industry is much smaller than it should be.

“The combination of regulation, successful performance and improved understanding of hedge funds is driving increased demand in South Africa,” concludes Zietsman. “It makes sense to allocate between 15% and 20% of your capital to hedge funds, run by active risk managers who have the ability to protect capital in negative market environments.” She reminds investors that generating and preserving wealth over time depends on the ability to compound wealth steadily and avoid large losses, both core features of the hedge fund offering.

As financial markets continue to face headwinds, portfolio diversification and risk management remain the best defence against financial market uncertainty. Hedge funds present a unique opportunity that is otherwise not available in the traditional investment space — and that makes them suitable building blocks for a wide range of investing activities.

“A suitable market environment for hedge funds is one that is characterised by high share price dispersion with moderate volatility; such an environment bodes well for stock-picking opportunities and is an excellent hunting ground for both buying and selling (shorting) companies,” Ngqondoyi concludes.

She says a relatively small allocation to hedge funds can have a significant positive effect on the risk-return profile of a diversified balanced fund, with only a small increase in the overall fee.