Most local hedge-fund investors are institutional investors in the retirement fund sector and it appears from research that they prefer the ‘fund of hedge funds” approach to the sector.
Private high-net-worth clients are not a major source of assets, mainly because of the relatively small grouping of wealth in South Africa and also because of the lack of retail-friendly structures that can attract investors from the wider market.
Risk management is important for the institutional investor and South Africa has taken a market lead in transparency, strong risk oversight and reporting to clients. Given the investment-risk profile of the major investors, South African investment mandates tend to be reasonably conservative and issues such as leverage responsibly managed.
This self-imposed conservatism is illustrated by the fact that thus far there has been only one fund failure in South Africa, which can be attributed to bad investment decisions, coupled with departure from the mandate restrictions.
The failure happened in 2007 and as a result the industry immediately took steps to improve controls and mandate monitoring. The Financial Services Board (FSB) is still investigating the collapse and will not be drawn on when its investigation will be completed.
The local industry is essentially hamstrung. It has been in discussion with the FSB for more than six years but there is still no regulated structure available to the hedge-fund industry under collective investment regulations. Because of this the sector has to operate within fairly complicated limited liability partnership and debenture structures. These structures can cater for the domestic institutional market and to a limited extent for high-net-worth individuals.
All is not lost, however, and the Alternative Investment Management Association has successfully concluded negotiations with the FSB on the regulation of hedge-fund managers. Early this year regulations were introduced with ‘fit and proper” rules for hedge-fund managers and the requirement that all hedge-fund managers must be approved by the FSB. This is a big step forward and the transition from being regulated only as investment managers to becoming a specific class with additional ‘fit and proper” requirements has been welcomed by industry and investors. Again, South Africa has taken the lead with the introduction of regulations offering better protection for all parties involved in the industry.
So what is attractive about hedge funds compared with other ways of investing money?
The term ‘hedge funds” is a bit of a misnomer: alternative investment strategies would probably be a better description. They involve a conglomerate of different investment management styles, processes and instruments that do not follow the traditional investment route of buying equities and bonds on listed markets and holding them. When markets are tough, the traditional alternative is cash.
Hedge funds, on the other hand, invest in listed and unlisted investments. They can ‘short” a share or market– in other words, sell something that they have borrowed but do not own in anticipation of buying the item back at a lower price.
Some hedge funds carry out arbitrage — buying and selling in different markets to take advantage of inefficiencies in markets — while others are now providing ‘mezzanine finance” for private equity-type deals. The main focus is still, however, the long/short strategy for most of the funds in South Africa and globally.
What hedge funds do is provide an alternative to the traditional market and when included in an investment portfolio they can complement the traditional type of investment and reduce overall portfolio risk. However, they are not suitable for an entire portfolio as they have their own particular risks.
What should South African investors be aware of?
Hedge-fund structures are unregulated in South Africa, which means that investors are not offered regulatory protection under collective investment scheme regulation, and there is no advertising or ‘open solicitation” to invest in these investment products.
Investors should have a clear understanding of what they are investing in and are strongly advised to seek a professional investment adviser with knowledge of this market. This applies to both domestic and international portfolios, where there are many hedge funds on offer.
Follow the lead of institutions by sticking to funds of funds. There may be an extra cost involved, but they are run by investment professionals who reduce specific fund manager risk further by investing in diverse strategies. If you are promised exceptional returns, be cautious. Remember that the higher the returns, the higher the possible risk.
Retirement funds are not investing in hedge funds because the funds are offering high returns: they are investing in hedge funds because they offer returns with low correlation to general market risks. And remember, as with other investments, past returns are no guarantee of future performance.
Ian Hamilton is chairperson of the South African chapter of the Alternative Investment Management Association, a global association for hedge funds