We vividly remember disasters. It’s why our palms sweat in mid-air turbulence, and why many investors turn cold when hedge funds are proffered.
Losses of such magnitudes are not only frightening, but run counter to what most hedge funds claim to be; absolute return vehicles targeting a positive return no matter the market’s gyrations.
Those familiar with these financial devastations have reason to be weary of hedge funds, as do nervous fliers when faced with an airline tarnished by a fatal crash.
But when viewed rationally, the probability of being involved in either a plane crash or a collapsed hedge fund is exceedingly small, especially when you’ve chosen your service provider carefully.
Individuals in South Africa are now able to invest in hedge funds. Yes, you can avoid them. Your situation may demand it. But that decision should be based on suitability, not on fear. We put forward a case for including hedge funds in your portfolio below.
Why you should consider them
It boils down to access. There are a number of investment strategies that, as a traditional long-only investor, are simply outside your reach. What can they offer you?
To start, these strategies attempt to generate returns that are uncorrelated to those of traditional investments like equity and bonds. If successful, the result is improved diversification, and by extension, your portfolio overall is subject to smaller losses when those traditional assets classes don’t perform well.
Enhanced investment return is also proposed. When a long-only manager identifies an overvalued asset in the course of their research, the most they can do is underweight it relative to their benchmark or, at best, leave it out of their portfolio altogether – they essentially pass on the opportunity to profit from a mispriced asset.
Hedge funds can take ‘short’ positions that make money when overvalued assets fall in price. This additional investment subset begets more opportunity, which begets more return. The proviso here is that the manager is skilled enough to identify mispriced assets in the first place.
In theory, all investors should construct a portfolio that offers the highest return for the level of risk they are willing to accept. If hedge funds do indeed add diversification and return to your portfolio, including them in your investment stable will move you closer to that optimal portfolio.
The naysayers contention, and a rebuttal
Perhaps the biggest contention put forward by anti-hedge fund proponents is that the fees hedge fund managers charge are too high and that the returns are, in fact, unimpressive.
The fee debate can be nullified somewhat by comparing returns after fees are deducted, i.e. net of fees.
Ironically for the fee complainants, higher fees may have actually increased the proclivity of hedge funds to earn competitive returns as the most talented stock pickers migrated toward the higher incentive on offer. An argument for another day though!
Because we’re now comparing apples with apples using returns that are net of fees, the argument reduces to a simple comparison of returns. To get a result we graph the mean performance of three hedge fund strategies – the data compliments of Hedge News Africa – against the mean performance of what would be considered their traditional long-only equivalents.
The time frame we’ve chosen to analyse includes both a significant bear market, in the guise of the Global Financial Crisis of 2008/09, as well as the powerful bull market that followed it. Analysing a full cycle (both a bear and bull market) allows us to first test the hypothesis that hedge funds better protect capital in downward trending markets, and second, to examine whether they are able to keep pace with long-only strategies in upward trending ones.
Chart 1 highlights how South African Long-Short Equity Hedge Funds have performed against their traditional long-only competitor, SA General Equity Funds, using the mean cumulative performance of each strategy since 2007.
Chart 1: Protecting and performing
Source: INet, HedgeNews Africa
The first visual is pretty much the perfect advert for Long-Short Equity Hedge Funds. They provided greater capital protection (red line dropped less) than traditional SA Equity Funds (and against the market as a whole) during the Global Financial Crisis in 2008/09.
Impressively, they then matched both the blue and green lines during the ensuing bull market. More recently, their pedigree has again come to the fore in defying a sideways trending market that took root in early 2015 – something their long-only counterparts have failed to do.
The differentiating factor between these two strategies is that Long-Short Equity Hedge Funds can ‘short’ shares. This involves the investment manager identifying shares she believes will underperform the shares she holds long in her portfolios.
Once identified, the investment manager does the following; she borrows those shares from a broker or dealer with the promise to return them in the future; she sells those shares at the prevailing market price; she buys the shares back at a lower price at some point in the future; pockets the difference; and returns the shares to the lender, with a thinly veiled grin.
Having these short positions in your portfolio provides an element of downside protection as they perform well when markets trend downwards.
The cash received from the initial sale of the shares is used to buy more of the shares she holds long. Using borrowed money (the shares she sold were borrowed) to increase exposure to shares held long is known as leverage, one of the most important concepts budding hedge fund investors must grasp. Higher leverage amplifies your investment returns, both on the upside and downside.
The dominant risk – as with most hedge fund strategies – is that the long positions decline in value, with a simultaneous appreciation of the short positions.
Chart 2 below turns our attention to the fixed income space by comparing Fixed Income Hedge Funds to the SA Fixed Income Units Trusts.
It’s another accolade for hedge fund strategies. Fixed Income Hedge Funds have conclusively outperformed the long-only unit trusts playing in the same space, as well as the bond market as a whole, with less volatility (smoother red line).
Chart 2: Consistent alpha generation
Source: INet, HedgeNews Africa
There are a number of sub-strategies that fall under the Fixed Income Hedge Fund banner. An in-depth look at these strategies is beyond the scope of this piece. But briefly, they take positions based on their directional views of interest rates, and on whether debt instruments are yielding in accordance with their underlying credit fundamentals.
As with Long-Short Equity Funds, overvalued securities are ‘sold short’, using leverage to increase exposure to the fixed income securities deemed undervalued.
Because the returns generated by fixed income strategies are generally lower than those offered by equity, the leverage employed in the fixed income space tends to be greater (to ratchet up the smaller returns) than that used in equity-centric hedge funds. The higher leverage employed makes these strategies susceptible to greater losses.
To create a hedge fund composite that is comparable to the traditional Reg. 28 Balanced Fund Unit Trusts, Chart 3 uses the Hedge Fund Composite Index. This index best represents a balanced hedge fund strategy in our view, also known as a Multi-Strategy Hedge Fund.
Chart 3: More on the upside, less on the downside
Source: INet, HedgeNews Africa
Charts 1 & 2 showed that both the Long-Short Equity and Fixed Income Hedge Fund strategies have outfoxed their long-only counterparts. Unsurprisingly then, the index formed by combining these two strategies has outperformed the traditional balanced strategy. Again, there is less volatility in the red line.
Balanced strategies generally invest in multiple asset classes such as equity, bonds, cash and currencies, commodities, and property. But, as you may have guessed, hedge funds have the ability to take ‘short’ positions in each of these asset classes.
The ability to earn profits on the downside gives the red line its smoothness (less volatility), while greater exposure (using leverage) to the best performing asset classes is most likely responsible for the substantial gap between the red and blue line.
As with the long-short equity strategies, the risk is that your long positions decline in value while short positions appreciate. But the diversification that multi-asset/balanced funds offer means these products generally have a lower risk profile. The asset allocation aptitude of a balanced/multi-strategy hedge fund manager is of critical importance when considering an investment.
Driving it home
The adjacent tables add weight to the competitive return, lower volatility characteristics that hedge funds lay claim to. The top table shows the annualised returns for the period we analysed in the previous charts. The bottom isolates the bear market, showing the total returns generated over that period.
It’s quite clear, in a South African context, that hedge funds have proved their mettle. At the very least, an investigation into their suitability for your investment portfolio is warranted.
The hedge fund composites used above are subject to back-fill bias. That is, only those hedge funds choosing to submit their data are reflected in the composites, whereas all the long-only unit trusts are required to disclose their returns. The sample is also smaller because there are considerably fewer hedge funds than there are long-only funds.
More reasons to consider hedge funds
First off, investment products available to the man on the street attract heavier regulation. This should limit, or at least unveil, the excessive risk taking responsible for the large losses that a handful of hedge fund investors have taken on the chin.
Investors will also require education before stepping into these products, perhaps forcing an improved articulation from hedge fund managers as to how their products work. Both elements should bring the transparency needed to facilitate hedge fund investments by aspiring SA investors.
Secondly, market inefficiencies are becoming scarcer as swelling human intellect and artificial intelligence hound alpha opportunities. Hedge funds have an edge in this regard because the ‘short’ side of the market is less efficient than the long side, for a number of reasons.
For example, fewer investors are able to go ‘short’ so there is less coverage of these opportunities. Sell side analysts are also reticent to issue sell recommendations, fearing a backlash from company management. Hedge funds can exploit these remaining inefficiencies for their investors, while traditional long-only investors cannot.
And lastly, the hedge fund industry as a whole is still in its infancy. Hedge funds manage less money than traditional long-only managers, and are therefore able to adjust their positioning faster, earning the incremental returns afforded to the first mover.
Investing is a zero sum game. So just like traditional investment managers, there will be hedge fund managers that perform well, and those that perform poorly. What the charts above suggest is that South African hedge funds are capable of outperforming, or at least matching the returns of traditional investment products, but critically, with less volatility. Who wouldn’t want to lose less in bad times while retaining the ability to perform well in the good?
It’s important to realise that as an investor in a traditional, actively managed investment product, you inherently believe that the asset manager you’ve chosen can earn returns in excess of the market by identifying undervalued assets.
If they can identify undervalued assets, they can identify overvalued ones. Why wouldn’t you want access to both subsets?
At Obsidian Capital we manage both traditional long-only and hedge funds products. So in a sense we are providing this insight from a neutral viewpoint. We can testify to the benefits that hedge funds offer and commit to the declaration that hedge funds can be understood, can enhance return, and can provide better protection of your capital in downward trending markets.
The final two charts graph the performance of the hedge funds we manage, the Obsidian Multi-Strategy Fund and the Obsidian Long-Short Equity Fund against their appropriate alternatives.
Chart 4 & 5: Obsidian Hedge Fund Performance