Much still needs to be done to educate retail investors about hedge funds before the status quo can change.
The South African hedge fund industry boasts a successful track record since the launch of the very first hedge fund more than 25 years ago. Over the last decade, the median equity long-short hedge fund has outperformed traditional equity funds by close to 2% per annum, raising questions about the low exposure that retail investors have to this alternative, listed asset class.
In this context, widening the hedge fund offering to retail investors could allow ordinary South Africans to benefit from a different source of return, largely uncorrelated with the other asset classes in their portfolios. The Old Mutual Multi-Managers Long Short Equity fund of hedge funds (FoHF) was awarded, for the fifth consecutive year, the best fund of funds over 10 years at the HedgeNews Africa Awards 2022, with a net annualised return of 11.9% and a Sharpe Ratio of 0.90.
Although South Africa’s hedge fund industry has over R80-billion in assets under management, it has made little headway in attracting individual investors, with around 95% of the industry’s assets held by institutional investors, predominantly pension funds. Much still needs to be done to educate retail investors about hedge funds before the status quo can change.
The first step is to gain a basic understanding of hedge funds, described as funds that allow fund managers to generate returns from both buying or selling of various asset classes. In the long-short equity hedge fund space, fund managers can thus profit from increases in share prices, and from selling shares that they expect to fall in price, also known as “short selling”.
During periods of consistent market decline, long-short equity hedge fund managers enjoy distinct advantages over traditional long-only equity managers because they can profit from declining share prices. To illustrate this, over the period June to September 2022, the JSE All Share Index was down almost 10% compared to the median return of local long-short equity hedge funds which was up more than 1% over the same period, while the Old Mutual Multi-Managers Long Short FoHF delivered a 4% return, an almost 15% outperformance compared to equities over the same period, net of fees. This is because the mechanisms of short selling create other value opportunities for hedge fund managers.
So how do hedge funds generate alpha or excess returns for clients? When you short a share, you effectively borrow that share and sell it in the open market with the hope that the share price will fall and later buy it back at a lower price. The fund manager can use the cash generated from the sale to amplify fund returns by, for example, increasing exposure to shares that are expected to increase in value. Put another way, hedge fund managers can fund high-conviction views using the capital that they free up from shorting activities.
Retail investors are unlikely to succeed unassisted in the complex world of hedge funds, which is why it is important for independent financial advisors (IFAs) to provide professional advice on how hedge funds could enhance their overall investment portfolios.
Hedge funds are topical at the moment and we have seen a notable uptick in asset managers pushing their solutions in this space. We must, however, balance our marketing efforts with consumer education to ensure that retail investors have realistic expectations from this asset class as those who buy into hedge funds for the wrong reasons may be disappointed.
Financial advisors and fund managers have three motivations to encourage retail investors to increase exposure to hedge funds. First, the hedge fund industry is mature and well-regulated. Hedge funds have been available locally for almost three decades and have been regulated alongside traditional unit trust funds since 2015 when they were included under the Collective Investments Schemes Control Act.
This framework allows for two types of hedge funds to be created, namely retail investor funds (RIFs) and qualified investor funds (QIFs).
Second, local managers have extensive skill in managing hedge funds across a range of investment mandates. And third, fees have come down significantly since the early days.
Due to asset managers reaching critical mass we have seen a halving of the base fee, with increased competition driving down the performance fee when fund managers exceed their targets. Fund of hedge funds are usually able to negotiate even lower fees with hedge fund managers. Unit trusts can take advantage of this because they pool clients’ investments which sets them up perfectly to take advantage of the above.
Rather than be deterred by the fee, investors should focus on the return net of fees delivered by hedge funds and the diversification benefits that they offer.
The performance that we have seen from the hedge fund space has been stellar and is reported net of fees; while fees are a key consideration, it makes sense to focus on the value added by a well-diversified fund of hedge funds to an investor’s portfolio. The fact that some investors have zero exposure to hedge funds is a lost opportunity.