An alternative investment is a financial asset that does not fall into one of the conventional asset classes such as equity, bonds, property and cash. These conventional assets are mostly used within traditional investment vehicles such as unit trust funds or private share portfolios. The alternative investments space includes the likes of private equity, venture capital, hedge funds, art and antiques and derivative contracts.
The pandemic, coupled with the volatile markets we have experienced, has reaffirmed the necessity for a well-diversified portfolio for investors - to try and manage these risks. Alternative investments suit this environment well as they typically have a low correlation with conventional asset classes. This characteristic makes them a suitable tool for portfolio diversification, and therefore gives alternative investments the ability to deliver higher risk-adjusted returns.
This article pays special attention to Hedge Funds and the risks/rewards of investing in hedge funds.
What is a Hedge Fund? In simple terms, a hedge fund is an investment vehicle which employs different strategies to generate alpha (investment return above the market index). The term “hedge” is used because hedge funds typically apply strategies that hedge some of the risks faced by investors. This is performed by simultaneously buying and shorting shares, as well as through the use of derivative instruments.
Debunking Hedge Funds – What You Should Know Now
It is important to debunk some of the common misconceptions associated with hedge funds, as these can often create resistance to making use of this asset class.
Myth 1: Too Risky – Most South African investors still perceive hedge funds as a riskier investment when compared to other more conventional investments. South African-based hedge funds are in fact relatively conservative compared to international hedge funds. Locally, hedge funds are seen to be a very lucrative proposition for investors with a high risk and high return appetite. However, this is not the only type of investor who should be considering hedge funds. In this article, we will explore this in more detail as some hedge funds have proven to be less risky than the general equity market.
Myth 2: Non-Regulated – The Financial Services Conduct Authority (FSCA) has included hedge funds in the Collective Investment Schemes Control Act (CISCA). This is the same act that governs unit trust funds. This ensures that hedge funds are governed by the same regulatory and oversight parameters as unit trusts. The regulation classifies hedge funds into two categories, namely retail investor hedge funds (RIHF) which have more stringent regulation requirements, and qualified investor hedge funds (QIHF).
Myth 3: High minimums and only suited for high-net worth individuals – the above-mentioned regulations have made hedge funds more accessible to a broader investor base. Retail hedge funds are now available to the public. Qualified hedge funds can only be accessed by qualified investors, who are considered to be savvier investors and this includes institutional investors. QIHFs still require a minimum investment of R1 million, however, RIHFs’ minimums are much lower and depending on how you access them, can be as low as a R25 000 lump sum investment.
Myth 4: Not easily accessible – with the launch of retail hedge funds, which are priced daily with daily liquidity, these can now be more readily accessed either directly from the manager or via certain Linked Investment Service Provider (LISP) platforms. Along with investors seeking to diversify their risk and return sources, this increase in accessibility has improved the interest in hedge funds, specifically from the retail market. Furthermore, Regulation 28 of the Pension Funds Act (Act 24 of 1956) was amended to include hedge funds. Investors are now able to allocate up to 10% of their retirement contributions to hedge funds.
Risks
All investments carry a certain degree of risk and it is relative to each individual investor as to what risk is desired. With a clearer understanding of risk and the ability to appropriately diversify a portfolio, an investor may be able to better manage their portfolio risks. With better risk management, an investor will be able to obtain improved financial wealth, peace of mind and meet his/her financial goals.
Hedge funds have unique differences to other asset class from a risk perspective, but they have often been unfairly labelled as a far riskier asset class. Unfortunately, history has contributed to this misconception, with certain hedge fund managers having large blow ups in their funds (for example, during the 2008 financial crisis a relatively large number of hedge fund managers defaulted. Some hedge funds crashed for several reasons, including poor risk management, excessive leverage, and sometimes fraud).
However, here is a question to place this into perspective - are cars dangerous? The answer would invariably be that it depends on the driver of that car and the car’s roadworthiness. This is comparable to hedge fund managers - it depends on the fund manager responsible for managing the hedge fund, as not all hedge fund managers are created equal.
There are various ways a hedge fund manager can manage the risks within a portfolio. One core strategy is that the hedge fund manager should diversify their short book and prudently size the short positions. This will assist to protect against certain market shocks, like the so-called meme stocks that have surfaced in recent years. The manager should also remain flexible in their approach (whilst ensuring they have sound principles to follow as a team). This also equips the manager to be nimble and move in and out of positions quickly and when necessary.
Flexibility also ensures you can adjust your net and gross exposure to mitigate risk. Net exposure reflects the difference between the two types of positions held in a hedge fund's portfolio. For example, if 60% of a fund is long and 40% is short, the fund's gross exposure is 100% (60% + 40%) and its net exposure is 20% (60% - 40%). This percentage measures the extent to which a fund is exposed to market fluctuations. A fund with a lower net exposure typically carries less risk.
Lastly, having the ability to diversify geographically through investing both locally and offshore, will assist in diversifying the portfolio and reducing overall portfolio risk.
Rewards
Having ‘portfolio insurance’ became seen as the magic bullet that could ensure a portfolio will never experience a loss beyond a comfortable limit. Hedge funds can use their flexible structures and the ability to use leverage and shorting stocks to earn returns that are uncorrelated with other asset classes and ultimately provide some ‘insurance’ for a portfolio.
Including alternative assets, such as hedge funds, in an investment portfolio will result in diversification which, in turn, provides an additional layer of risk management. Diversification helps to ensure that investors are not overly concentrated in a specific type of asset class. Hedge funds are typically less correlated with the market and can help to reduce risk within a portfolio. Unlike traditional equity funds, hedge funds are not dependent on overall market sentiment and on rising equity values. This opens a whole new opportunity set for investors to profit from.
Hedge funds aim to deliver positive returns in both bull and bear markets. Not only can profits be had in rising markets, but they have the added benefit of being able to make profits on companies that they believe will decrease in value. This is achieved through a process called short selling. A traditional long only unit trust is unable to employ this strategy. This risk mitigation strategy also provides a hedge fund manager a whole additional sub-set of shares to invest in. This ability gives the manager added optionality of protecting assets and delivering positive returns, irrespective of market direction.
All the above-mentioned rewards give the portfolio both the ability and flexibility to provide better protection on the downside, while capturing performance on the upside. This in its entirety can be extremely rewarding for an investor.
In order to illustrate how 36ONE has been able to manage the above risks and deliver rewards consistently and successfully to their investors, please see the below statistics:
| 36ONE SNN QI Hedge Fund | FTSE/All Share Index | |
|---|---|---|
| Performance p.a. since inception (net of fees) | 16.1% | 11.3% |
| Volatility p.a. since inception | 8.3% | 15.0% |
| Largest drawdown since inception | -12.6% | -40.4% |
| Largest drawdown in last 3 years | -8.9% | -21.7% |
| Up and down months since inception | 137 up 48 down |
113 up 72 down |
Disclaimer:
Collective Investment Schemes are generally medium- to long-term investments. The value of participatory interests (units) may go down as well as up. Past performance is not necessarily a guide to future performance. Collective investments are traded at ruling prices and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions, as well as a detailed description of how performance fees are calculated and applied, is available on request from Sanne Management Company (RF)(Pty) Ltd (“the Manager”). Full mandatory disclosures can be obtained on our website by following this link: https://www.36one.co.za/legal/disclaimer. 36ONE Asset Management Pty Ltd is a licensed financial service provider. FSP# 19107