To some people hedge funds are unfathomable investments which grab international headlines when risky bets result in a sticky end. In South Africa however hedge funds and hedging strategies are mostly used to protect investors’ capital. We look how hedge funds and unit trusts with defensive strategies are used to ride out the volatile markets.

A hedge fund is simply an investment strategy, explains Stephen Brierley, Head of Hedge Funds at Symmetry, Old Mutual’s multi-manager investment business.

A hedge fund is able to invest in any asset class and is far more flexible than a unit trust which is limited to the rules set by the Collective Investment Schemes Control Act (CISCA). As hedge funds operate in a less regulated environment they can set broader investment mandates than a traditional unit trust fund.

A hedge fund can invest in equities, it can trade the futures market, the currency markets, the bond market and the cash market in its search for optimizing performance. A hedge fund can also “short” a share or an index which means the fund can actually make money in a falling market, or at the very least protect an investor’s capital.  A traditional fund manager can only go “long” which means they have to hold a share even if they are concerned about short-term market movements.

Another advantage is that a hedge fund can “leverage” which means it can have more exposure to the market than the value of the fund. This is done by investing in the derivative of the share rather than the actual share. This means the fund has exposure to the share by paying a deposit (or margin) without actually having to buy it.

With a “long” position, the fund manager is hoping that at the end of the contract the actual underlying share price will be higher than the purchase price and therefore make a profit. With a “short” position the fund manager hopes that the share is trading at a lower price as the fund manager has actually sold the share with the hope of buying it back at a lower price.

Brierley says hedge funds are the ultimate stock picking fund as a fund manager can take positions on their preferred shares and are not constrained by a relative weighting to an index. CISCA limits the maximum exposure a traditional unit trust fund manager may have to a specific share.

How it works:

An equity hedge fund manager selects around 30 shares that he or she believes will deliver performance over time. However the manager is concerned about the general market volatility over the short-term. The fund manager can then, using derivative products like futures and options, short the FTSE/JSE Index which effectively means they have sold the index in the hope of buying it back at a cheaper price. If the market does fall during the time that the short position is held, then the fund manager will make some money out of the short position to offset the losses on the portfolio of shares, thereby protecting the investors’ capital.

Another strategy that a hedge fund may use is pairs trading. Here the fund manager uses their stock picking skills to make money from both falling and rising shares. For example the fund manager may prefer resources to retailers and takes a bet that Sasol will outperform Truworths. The fund manager may buy Sasol and go short Truworths. If Sasol goes up and Truworths falls, the manager scores on both shares. But even if the market as a whole falls, then the manager expects Sasol to be more resilient and for Truworths to fall further. The bigger fall in Truworths offsets the losses in Sasol so the net position is still positive. It’s a relative value gap bet. The risk is that the manager’s sector call is incorrect and Truworths rises in value while Sasol’s share price falls – this creates a double loss.

Regulation

One of the concerns with hedge funds is that they are not regulated by the Financial Services Board. This means that there is not the same level of protection for the investor as is the case with unit trusts. Therefore one needs to thoroughly investigate a fund manager before investing.

While the products are not regulated, the fund manager is regulated under the Financial Advisory and Intermediary Services Act (FAIS) under sections specific to the hedge fund industry.

“Although hedge funds are not currently available in the unit trust space, the hedge fund industry is working on a framework to include them in the future,” says Brierley who explains that while unit trusts have been around for decades, hedge funds are relatively new and people do not always understand the use of derivative instruments, leveraging and shorting. “We need to make sure they can be regulated properly,” says Brierley.

Accessibility

Most hedge funds have a minimum investment requirement of at least R500 000 and therefore are not aimed at the retail market. Hedge funds tend to deal mostly with institutional clients such as pension funds and high net worth individuals. However there are Fund of Hedge Funds which invest in a variety of underlying hedge funds which are more accessible to the public if bought through a life “wrapper” such as an endowment for example. Companies like Blue Ink, which is part of Sanlam, offer these types of funds.

Pension funds and retirement annuities are allowed to invest a maximum of 10% into hedge funds and multi-fund managers like Symmetry use hedge funds as part of a building block in creating a total investment solution for clients.

Fund of Hedge Funds is a safer way for an individual to invest as they are diversified across a range of hedge funds and the investment manager offering them has performed the research into the managers. “The hedge funds we deal with are very transparent to us and disclose their information, however they would not be comfortable disclosing their intellectual capital to just anybody,” says Brierley.

Although hedge funds are not available on a unit trust platform many asset allocation or real return/absolute fund unit trusts use hedging strategies to protect investor’s capital. For example funds that focus specifically on capital preservation such as Allan Gray Optimal fund and the Prescient Equity Defender Fund use certain equity derivatives that are allowed by the CISCA to reduce their exposure to the equity markets when they are concerned about the market trend.

This article first appeared in City Press