Last week while I was driving home, listening to one of my favourite podcasts, an interesting discussion came up on hedge funds. While I enjoyed the coverage of hedge funds, I found the tone of the conversation dressed in fear and wariness. It was acknowledged several times in the interview that hedge funds confuse the average investor.
This may be true when compared to an equity fund, which intuitively makes sense to the man on the street; however, try explaining an income fund which uses bonds, FRNs, ILBs, structured notes, and other instruments wrapped in colloquial jargon. Investors trust these lower heartbeat income products with their most sensitive short-term investments, often without regret. However, unexpected events can occur, even in income funds, as seen recently when Bridge Taxi Finance defaulted on their loans.
I agree that investors should not go blindly into any investment, and hedge funds do require a bit more understanding, but over time they have proven their value-add to the investment mix. By their very name, hedge funds should instil positive risk management sentiment for investors, ‘hedging your bets’.
With a broader toolbox, hedge funds can manage the various possible downside scenarios while not giving up all of the upside. A typical hedge fund may have a starting point of aiming to capture 2/3 of the upside, while mitigating 2/3 of the downside. By missing most of the drawdowns, the funds more than make up for not participating in all of the upside. But given their range of investment opportunities, different hedge funds will seldom behave similarly and may be styled to capture less of the downside or more of the upside.
Correlation matrices illustrate how effective hedge funds are at diversifying a portfolio relative to both asset classes and other hedge funds.
The other notable point made during the discussion was how some hedge funds can blow up in times of extreme stress and black swan events. While this can be proven internationally, within South Africa, our hedge fund industry has proven itself relatively resilient through each of the last few crises. The below chart shows the average Long Short and Market Neutral Fund in the last few crises.
The interviewer questioned whether survivorship bias was at play in the hedge fund industry. After a bit of researching with HedgeNews Africa, the attrition rate of hedge funds in SA is between 7% to 8% on average over the past 14 years. This is in line with funds in the unit trust industry where smaller funds fall out or are amalgamated into new strategies.
Many steps have been taken to improve hedge fund access and regulation over the years. Most of the tried and tested Retail Investor Hedge Funds (RIFs) are now listed on major platforms, offering the man on the street access to some of the best investment minds in the country. These funds are limited to 2x gearing, much less than one would typically take on a house with a bond.
An important point to make is that RIFs are traded daily with daily liquidity. They are governed by the same regulations and requirements as unit trusts in South Africa, limiting any fund closures or exit penalties. With long track records, established processes and philosophies, the experienced portfolio managers usually have their own wealth invested in the funds alongside their investors.
At Laurium, we believe that hedge allows us to express our view in the most effective way. Please visit our website to view and invest in our range of hedge funds. www.lauriumcapital.com
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