There’s no doubt that by association with sub-prime and derivatives, hedge funds have fallen from grace since 2007. Bruce Simpson, a hedge fund manager at SIM (Sanlam Investment Management) confirms that after strong growth during 2004-2006 when the industry grew from R4 billion to R30 billion, the industry has stalled at that level, pending both changes to regulation 28 and further regulation of hedge funds themselves by the Financial Services Board.
Regulation 28 has now been amended and will bring major changes to the hedge fund industry. In the past, hedge funds could never market directly to the public — hence investors are primarily institutional — and this will remain the case for the next 12 months until regulation is expected to permit it. However, hedge funds remain popular with high net worth investors (HNWIs) for the diversification they offer and the fact that managers are intensely focused on a smaller amount of money than is typically the case with a traditional equity manager.
Simpson explains that a hedge fund manager may typically run small funds ranging from R100 million to R1 billion compared to traditional equity managers who run much larger funds often in excess of R20 billion. Furthermore, he explains that his own team of two managers has an aggregate 30 years of investment experience; so while traditional managers may have similar experience their focus is spread a lot thinner because of the size of their funds.
Often experienced traditional fund managers morph into hedge fund managers for the challenge. Hedge fund managers have more tools available to generate returns and are highly incentivised toward performance. There is an almost complete synergy and alignment of interests.
Simpson says the reliance on skills is a core feature of the hedge fund industry. “In the unit trust world, as much as 90% of the return is beta (the market) and only 10% alpha (stockpicking). This ratio is reversed in the hedge fund world.”
Nonetheless, before looking at the advantages of the hedge fund manager the first decision to be made is whether to invest in a hedge fund at all. Their primary advantage is additional diversification, which in turn is due to their large non-correlation with equities.
Much larger toolbox
Most people attribute this to the fact that hedge fund managers can go either long or short (that is, sell when the shares are falling and buy back at a lower price). Simpson says while this is an important tool in their arsenal, it is not the major one. He likens a hedge fund to a hybrid of a traditional manager (albeit one that can go long and short) and a treasury manager, buying swaps, hedges, futures and the vast array of tools that they have on the fixed income and currency markets.
The result of all these tools, explains Simpson, is that when a traditional manager loses 20% on the market (as in 2007/8) a hedge fund can make 15% to 20%. But by the same token, when an equity-only fund makes 40% a hedge fund will not emulate that performance.
The ‘bad name’ that hedge funds had is due to the fact that they have many different strategies — some highly aggressive and leveraged. Hurt by association, in fact most hedge funds are conservative and fulfil the role of risk mitigation within an investor’s portfolio.
The average investor is unlikely to have the time and dedication to understand each of these strategies or be able to do his own due diligence on each fund. The most popular vehicle for private investors is therefore the fund-of-funds, which do the due diligence on behalf of investors, and are offered by most major investment houses including SIM. They are also risk profiled to suit individual risk appetites, explains Simpson.
For this reason, private investors ought to similarly invest through a fund-of-funds. There has already been a natural clean-out of the industry during the past three years with the number of funds dropping from 160 to 120, and some hedge funds have been bought out by large investment houses. This is partly due to the dip in the market and partly in anticipation of regulation which is likely to make smaller independent funds unviable, says Simpson. Today, roughly 80% of the capital under management is run by the top ten managers.
With all the anticipated changes almost behind the industry, Simpson expects a resumption in its exponential growth: “We should see at least a doubling of the industry over the next five years,” he says.