We so often hear the timeless adage “Don’t put all your eggs in one basket”, or the famous quote by Harry Markowitz, the inventor of modern portfolio theory, “Diversification is the only free lunch in investing”.
These quotes seem simple enough to explain that holding a broader range of assets can result in better returns without assuming more risk. However, the sheer number of Discretionary Fund Managers (DFMS), institutional consultants, multi-managers, portfolio managers and other allocators of capital employed in our investment industry would suggest that this is quite difficult to achieve in practice – with as many variations as there are industry players of how best to create an optimal portfolio.
The concept of diversification is vital for investors to grasp. The future is unpredictable, and markets are therefore hard to foresee with any degree of certainty. Different categories of investments respond to changing economic and political conditions in different ways. By including different asset classes in your portfolio, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. How investments move in relation to each other is all about correlation, which describes the extent to which securities or asset classes rise and fall together. The best diversifiers in a portfolio are those securities or investments that are less or even negatively correlated.
It is quite surprising, therefore, that hedge funds in South Africa, given their low and negative correlations to traditional asset classes (equities, bonds, and cash) are so underutilised. The ASISA Collective Investment Scheme (unit trust) industry is R3.6tn strong, yet hedge funds with AUM of R151bn make up less than 4% of industry assets!* The correlation matrix below shows how Laurium’s conservative Market Neutral Prescient RI Hedge Fund has a negative correlation to cash, and a low correlation to SA Bonds and SA Equity. SA Bonds in fact have a higher correlation to SA Equity than the Market Neutral Fund.
Not only do hedge funds have a low or negative correlation to other asset classes, but within the hedge fund industry, many of the funds have very low correlations to each other, due to the unique way that hedge fund managers derive alpha though leverage, net exposure, as well as their long and short book. Quite simply, the broader the toolbox of potential instruments one can use, the less likely that two funds will look alike. Unlike long only funds, which are limited by mandate, regulation or asset class, hedge funds have far fewer constraints and hence can look and behave very differently. This means that combining some of the top managers’ hedge funds should make sense. In the matrix below, we have used some of the leading funds in the industry that have the longest track records.
This contrasts starkly with popular large balance fund peers, which are highly correlated with each other (typically around 0.90) and the market (typically 0.80 and above).
If the above figures are not convincing enough, perhaps one should consider how the smart money is invested. Arguably, the largest university endowment funds are run by the best investment brains in the world. A university endowment portfolio features many types of investments, with the overall goal of maximising returns while limiting risk. Alternative assets are an important reason why endowments have done so well. These funds have a significant allocation to hedge funds, as indicated in the graph below.
Disclaimer: Laurium Capital (Pty) Ltd is an authorised financial services provider (FSP 34142). Collective Investment Schemes in Securities (CIS) should be considered as medium to long-term investments. The value may go up as well as down and past performance is not necessarily a guide to future performance. CISs are traded at the ruling price and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions is available on request from the Manager. A CIS may be closed to new investors in order for it to be managed more efficiently in accordance with its mandate. Performance has been calculated using net NAV to NAV numbers with income reinvested. There is no guarantee in respect of capital or returns in a portfolio. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). For any additional information such as fund prices, fees, brochures, minimum disclosure documents and application forms please go to www.prescient.co.za. A Feeder Fund is a portfolio that invests in a single portfolio of a collective investment scheme which levies its own charges, and which could result in a higher fee structure for the feeder fund. The Laurium Enhanced Growth Hedge Fund is approved under section 65 of CISCA
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