There are many investments that fall under the “alternative investments category”, the most common of which are hedge funds, private equity, commodities, real assets, direct investments in start-ups and private companies, and venture capital. All are very different in terms of their legal structures, governing legislation, fees, tax treatment, transparency, risk and the returns that they can generate. What they do have in common, is that they are typically a lot more complex than traditional long only unit trust investments, are generally not well understood by investors, and importantly, do offer diversification benefits. Allocating a portion of your investment to alternative investments can enhance the overall returns, reduce your risk and should be considered as one of the building blocks of a well-diversified investment portfolio.
Fortunately, in South Africa, hedge funds have been regulated under CISCA since 1 April 2015. The regulations offer investors looking for different investments and diversification the opportunity to invest in fully regulated products. They are designed to complement long only funds, not replace them, for the following reasons:
- Increased diversification benefits
- Equity-like returns (after fees) with lower risk
- Protection of capital
- Diversification – better risk adjusted returns
- Highly regulated environment
Like any investment looking to outperform cash, hedge funds are not without risk. Fortunately, hedge fund managers in South Africa have proven themselves to be more conservative than their international counterparts; there are several experienced boutique managers that have long, consistent track records to prove it.
A few things to consider when evaluating a manager:
What is the manager’s skills set?
Long only fund managers analyse stocks, make decisions to buy, sell or hold; and make sure their funds are compliant with mandates and regulations. Hedge fund managers need to be able to do this well – and more. Hedge funds can use leverage, and other strategies such as shorting for example. To assess these skills, you need to dig deeper than you would for a long only manager. Managing hedge funds can be more complex than long only funds, and so requires a different skill set.
Have the fund managers and owners invested their own money in the funds?
You want a manager who has skin in the game and is prepared to invest a large proportion of their investable assets in their own funds – it shows they believe the fund can deliver on its objective and aligns their interests closely with that of their clients.
Is the manager transparent?
How willing is the manager to share information on attribution for instance? You should choose a manager that communicates well with their clients, to ensure that their clients are well informed and understand the risks of their investment.
How are the hedge fund managers incentivised?
Incentivisation is key to attracting top talent and ensuring a stable, committed team. Not only are financial incentives important, but the non-financial elements, like work environment, that should be fostered to create a close-knit, performance orientated team.
What about liquidity and leverage?
When evaluating a hedge fund, you must look at leverage and liquidity. It is a myth that all hedge funds are high risk, but when there is a lot of leverage the risk can increase. Liquidity is also really important. Some of the hedge fund failures have been because of liquidity issues. Hedge fund managers need to manage liquidity very carefully and investors must understand the risk and liquidity of the fund.
How much do you think should be allocated to non-traditional assets?
There is no rule – it will depend on individual circumstances. At least 15-20% of an investor’s portfolio should be invested in assets that are non-correlated to traditional investments. Regulation 28 allows for a 10% allocation to hedge funds, internationally we are seeing a higher and an increasing allocation to alternative investments.Written by: Kim Zietsman, Business Development and Marketing, Laurium Capital