Hedge funds: Protecting retirement fund returns

Although seen largely as risky and speculative, hedge funds act as an ‘insurance policy’ if used appropriately

In July 2022, National Treasury published new regulations pertaining to the maximum allocation retirement funds can make to certain asset classes, including hedge funds.

Following the amendments to Regulation 28 of the Pension Funds Act in July 2022, retirement funds are allowed to allocate up to 10% of their capital to hedge funds. The maximum allocation to a single hedge fund is 2.5%, while that of a fund of hedge funds is 5%.

Previously, hedge funds were grouped together with private equity funds as an asset class.

Pros and cons

The change in allocation limits allows for retirement funds to get the full benefit that hedge funds typically offer, including:

• Portfolio diversification: Hedge funds may offer low correlation to traditional equity and fixed-income markets. In other words, when the equity markets decline sharply, a low-correlated hedge fund could perform better or even deliver positive returns.
• Reliable returns: Hedge funds are structured to outperform markets in times of volatility, due to their low correlation to traditional assets, and especially during market downswings.
• There are also some pitfalls to consider:
• Fees: Management and performance fees are typically higher than normal unit trust fees. This is due to the more complex strategies employed by these funds, with their accompanying higher expenses.
• Lock-in: As hedge funds are not limited to which assets they are allowed to invest in, these may typically include unlisted assets. The latter cannot be readily traded, as is the case with listed equities, which results in a ‘lock-in’ of some of the fund’s underlying capital. The fund manager bridges this liquidity issue by placing a restriction on when money can be withdrawn typically monthly or quarterly for large investors.

What is hedging?

According to Investopedia, the best way to understand hedging is to think of it as a form of insurance.

When people decide to hedge, they are insuring themselves against a negative event’s impact on their finances. This doesn’t prevent all negative events from happening. However, if a negative event does happen and you’re properly hedged, the impact of the event is reduced.

In practice, hedging occurs almost everywhere. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.

Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

Technically, to hedge requires you to make offsetting trades in securities with negative correlations. Of course, you still have to pay for this type of insurance in one form or another.

For instance, if you are long shares of XYZ corporation, you can buy a put option to protect your investment from large downside moves.  However, to purchase an option, you have to pay its premium. A reduction in risk, therefore, always means a reduction in potential profits.

Therefore hedging, for the most part, is a technique that is meant to reduce a potential loss (and not maximize a potential gain). If the investment you are hedging against makes money, you have also usually reduced your potential profit. However, if the investment loses money, and your hedge was successful, you will have reduced your loss.

What is a hedge fund?

Hedge funds have been around since the 1950s, with the first hedge funds in South Africa appearing in the 1990s. Although initially reserved for high-net-worth individuals, private clients and certain institutional investors, South African retirement funds and retail investors now have access to hedge funds.

Generally, hedge funds are not well understood. Proponents view hedge funds as opportunities to gain exceptional returns, even in falling markets. They also view hedge funds as aiding the financial market in discovering the real prices of overvalued assets.

Meanwhile, detractors view hedge funds as carrying excessive risks for investors, as well as the economy. This view is based on hedge funds’ ability to enter into leveraged positions and betting against macroeconomic trends.

Often these opinions from both proponents and detractors are formed without a clear understanding of how hedge funds operate.

Hedge fund structure and strategy

In South Africa, as is the case globally, the hedge fund manager typically consists of a team of licenced specialist investment professionals that in accordance with the rules and methods of the fund agreement manages the fund.

As most South African hedge funds now operate under CIS trust arrangements, similar to traditional unit trusts regulated under CISCA, the hedge fund managers (as well as other key service providers, such as brokers and auditors) are typically appointed by the hedge fund management company.

Although the management company structure adds costs, it plays an important role in the governance, valuation, and risk management of the hedge fund.

Hedge funds can vary greatly in the investment strategies they employ. The chosen strategy will determine how the fund is managed, and forms the basis on which investors make their decision to invest. These strategies typically enable hedge funds to take positions against a certain expectation in a market in order to optimise risk-adjusted returns.

Most hedge funds in South Africa operate a combination of long positions (buy, hold, and sell) and short positions.  Short positions are achieved through ‘short selling’ or buying put options.  Short positions are taken where fund managers expect that asset prices will decrease in future.

An example is where a hedge fund short sells a particular share because its research on the company leads to the view that the future price will fall below its current price, thereby enabling the fund to profit from market price movement.

Hedge funds also use leverage to amplify the position it takes in the market. In practice this means that the fund utilises debt to take a position size in excess of its current available capital.

Allocation to hedge funds

Hedge funds are regulated in South Africa in accordance with the Collective Investment Schemes Control Act. Basically, the Act differentiates between two types of investors in hedge funds retail (individuals) and qualified investors (institutions).

Hedge funds are also divided into these categories. Retail investor funds have a less risky investment approach, whereas qualified investor funds are aimed at experienced and institutional investors (such as retirement funds). The latter should also be able to invest R1 million or more in a fund.

The regulation of hedge funds has opened the door for any person who can meet the minimum monthly contribution and accept the lock-in period, to invest in these funds. The contributions are typically at the higher end of what unit trusts require, but still manageable for individual savers.

Most retail investor hedge funds allow for monthly and one-off contributions.  Thus, gone are the days when hedge funds were perceived only as an investment for high-net-worth individuals.

Explaining hedge fund fees

The fees charged by hedge funds may seem expensive at first glance.  Running a hedge fund, however, can be more expensive than managing a unit trust.  The aggregate value of a fund’s under-lying assets is also an important determinant of the fee percentage.

Let us consider an example.  By the end of 2021, the total assets under management by hedge funds were R86.9 billion split between 216 funds, whereas SA’s largest single balanced fund had R156.2 billion under management at year end.

Certain fund expenses, such as research, staff costs, marketing and administration, are fixed and almost the same for a small R100 million hedge fund as for a R100 billion unit trust. For this reason, it is important to consider a fund’s returns net of fees, rather than a total investment charge, when comparing various funds.

Hedge funds typically split their fees, in a similar way as unit trusts, as follows:

• Total expense ratio: The percentage of the average net asset value of a fund that was incurred as expenses, levies, and fees with respect to the management of the fund.
• Transaction costs: The percentage of the net asset value of a fund expensed as costs to buy and sell assets for the fund.
• Performance fees: The fund manager’s cut, charged as a percentage, on the outperformance of the fund above its benchmark. This fee is usually included in the total expense ratio and should, for the sake of transparency, be disclosed separately in the monthly fund fact sheets.
• Total investment charges: The aggregate of the total expense ratio and transaction costs, expressed as a percentage of the fund’s net asset value.

When considering the total expense ratio of different hedge funds, it is important to note that a high ratio does not necessarily relate to poor performance and a low ratio does not mean good returns.

Deciphering the jargon

Derivatives: Financial instruments that derive their value from underlying securities and other variables, such as indexes or reference rates, have either no or small initial investment and allow firms to speculate or hedge risks that arise from factors outside their control, such as foreign currency rates.

Financial instruments: Assets that can be traded, or they can also be seen as packages of capital that may be traded.  Most types of financial instruments provide efficient flow and transfer of capital all throughout the world’s investors.  These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.

Futures: An exchange-traded contract for delivery of a standard equity of a specific underlying asset at a predetermined price and date in future.

Leverage: Gaining an economic exposure that is larger than available capital resources.

Long hedge: Buying a futures contract (e.g., by a commodity consumer) to hedge against a rise in the price of the underlying asset.

Long position: A dealer that has purchased a security is said to be “long” that security.

Net exposure: Net exposure is the difference between a hedge fund’s long positions and its short positions. Expressed as a percentage, this number is a measure of the extent to which a fund’s trading book is exposed to market fluctuations.  Net exposure can be contrasted with a fund’s gross exposure.

A fund has a net long exposure if the percentage amount invested in long positions exceeds the percentage amount invested in short positions, and has a net short position if short positions exceed long positions. If the percentage invested in long positions equals the amount invested in short positions, the net exposure is zero.

Option: A contract that gives the holder the right, but not the obligation, to buy or sell and underlying instrument at an agreed price

Put option: An option that permits the holder the right, but not the obligation, to sell an underlying asset at an agreed price.

Short hedge: Selling a futures contract (e.g., by a commodity producer) to hedge against a fall in the price of the underlying asset.

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your adviser for specific and detailed advice. Errors and omissions excepted (E&OE).