The pros and cons of using a hedge fund

Advantages of using hedge funds

1. Absolute returns potential (regardless of market direction)

The mantra of traditional long-only fund managers is perhaps best encapsulated by the statement that “time in the market” is more important than “timing the market”. The investment thesis of this approach is built on the foundation of compounding returns. Albert Einstein referred to compound interest as the eighth wonder of the world. Who are we to question the view of such a genius?

Yet investment markets don’t always go up in a consistent straight line and often experience deep dips in value. These dips may be seen as buying opportunities by long-only managers but if one doesn’t have the cash to take advantage of such dips, it’s a futile pursuit. Buying such dips provides the advantage of rand-cost averaging one’s entry into an investment, in so doing providing the opportunity for achieving a greater return in the long term.

In contrast, one of the pros of using a hedge fund is that the fall in the price of a security or a market isn’t necessarily seen as a value-detracting event, but potentially a value-generating opportunity. The hedge fund has the potential to take advantage of the power of compounding in a more profound way than a long-only fund, as it can limit any losses on the downside and even potentially generate gains. As Warren Buffett is alleged to have said, the first rule in investing is not to lose money and the second rule is to take note of the first rule.

Hedge funds can generate positive returns in both rising and falling equity markets. They achieve this through various techniques including: 

• Short selling: Profiting from a decline in asset prices.
• Derivatives: Using options, futures and other financial instruments to hedge against risk or magnify returns.
• Arbitrage: Exploiting small price discrepancies between related assets.

This ability to generate “absolute returns” (positive returns regardless of market direction) is a core appeal of hedge funds.

2. Diversification and low correlation

The strategies that hedge funds employ are usually uncorrelated with traditional asset classes like equities and bonds. This means that their performance doesn’t necessarily move in sync with the JSE All Share Index or the bond market. This low correlation is a significant benefit for portfolio diversification, as it can help to reduce overall portfolio volatility and lead to smoother returns over time. When traditional markets are struggling, a well-managed hedge fund might still deliver positive returns, acting as a “shock absorber” for a portfolio.

3. Risk management and capital preservation

As the name implies, many hedge fund strategies are designed with risk management and capital preservation in mind. The “hedging” aspect aims to protect against downside risk.

South African regulated hedge funds, especially Retail Investor Hedge Funds, operate under strict regulatory oversight by the FSCA. This includes limitations on leverage, concentration and requirements for independent valuation and robust risk management frameworks. This can often make them more conservative than traditional long-only funds.

When traditional markets are struggling, a well-managed hedge fund might still deliver positive returns , acting as a “shock absorber” for a portfolio

4. Access to specialised expertise and strategies

Hedge fund managers are often highly experienced professionals with specialised knowledge in various market segments and complex trading strategies. Investing in a hedge fund allows retail investors to access these professionals and their sophisticated strategies that might otherwise be unavailable to retail investors. This has been a significant benefit of the introduction of the Retail Investor Hedge Fund
(RIHF). It could be seen as a masterstroke on the part of the FSCA to “democratise” the hedge fund industry.

5. Enhanced liquidity (for RIHFs)

In line with this “democratisation”, the regulation of RIHFs has led to these funds having daily pricing and daily repurchases. This provides a level of liquidity that was historically not always available with hedge funds, making them more accessible and manageable for retail investors.

6. Tax efficiency (capital gains tax)

Similar to traditional unit trusts, profits from hedge funds are generally subject to capital gains tax (CGT) rather than income tax. This can be more tax-efficient for investors, especially compared to investments that generate significant interest income. It is also possible to “wrap” hedge funds in tax-efficient vehicles like endowments, retirement annuities and living annuities.

Disadvantages of using hedge funds 

1. Potentially higher fees

Hedge funds typically charge higher fees than traditional unit trusts. This often includes a management fee (1-2% of AUM) and a performance fee (a percentage of the profits generated above a certain hurdle rate, eg 10-20%). While hedge fund managers may argue that these fees are justified by their specialised expertise and the potential for absolute returns, higher fees do erode net returns.

2. Complexity and understanding

The strategies employed by hedge funds can be complex and difficult for the average investor to fully understand. Despite the robust FSCA and CISCA regularity oversight of hedge funds, the complexity of hedge funds could be perceived as a lack of transparency for some investors. It’s crucial for financial planners to understand the specific strategies and risks of the hedge fund they are considering for their clients and to feel comfortable that they can explain this clearly to their clients.

3. Potential for underperformance

Despite their sophisticated strategies, hedge funds are not guaranteed to outperform. Some may still deliver disappointing returns, especially if the manager’s strategy does not align with market conditions or if their investment calls are incorrect. As with traditional long-only unit trust funds, past performance is not indicative of future results and even highly skilled managers can experience periods of underperformance.

4. Reliance on manager skill

Hedge fund performance is often highly dependent on the skill and experience of the individual fund manager or team. If a key manager or team member leaves or makes poor decisions, it can significantly impact the fund’s returns.

5. Liquidity risk (for QIHFs and some older structures)

While RIHFs offer daily liquidity, some Qualified Investor Hedge Funds (QIHFs) offer unregulated hedge fund structures that may have less frequent redemption periods (eg monthly, quarterly, or even longer lock-up periods). This can limit an investor’s ability to access their capital quickly if needed.

6. Limited track records (for some funds)

While the South African hedge fund industry has matured, some funds may still have relatively short track records compared to established unit trusts. This can make it harder to assess their long-term performance and consistency.

7. “Black box” perception

Despite regulatory efforts to increase transparency, some investors may still perceive hedge funds as “black boxes” due to the intricate nature of their strategies and the proprietary trading methods employed.

For South African investors, hedge funds offer attractive benefits in terms of diversification, potential for absolute returns and professional risk management, especially with the increased accessibility and regulation of RIHFs. However, these benefits often come with higher fees, a need for a deeper understanding of the strategies and the inherent risk that any investment can underperform. It is vital for financial planners and asset consultants to conduct a thorough due diligence before allocating their client’s capital to hedge funds.