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Hedge funds have been getting a bad rap in recent years due to poor performance coupled with high fees. While both 2016 and 2017 were pedestrian years for hedge funds, stronger numbers came through in 2018. The broader South African equity market was down in 2018 by -14% with a volatility of 12%. On average, the dominant South African hedge fund strategy – long short – outperformed the markets significantly returning marginally positive returns, though with a wide range of volatilities.

This comparison may prompt some investors to take another look at hedge funds; but therein lies the rub. It’s inappropriate to compare these instruments to their larger rivals, namely, long equity, fixed interest and cash; they’re vastly different animals.

Of the multitude of hedge fund strategies used globally, many South African hedge fund managers focus on just two, namely ‘long short’ and ‘market-neutral’. Yet, even within these two strategies many different tactics are used to achieve many different objectives, so it is practically impossible to make accurate comparisons.

Take, for example, the following sample of long short funds:

 Table A: Long short Strategies

Sample Fund12 month return 2018VolatilityGross Exposure
Fund A-18%22%275%
Fund B-16%12%179%
Fund C3%10%150%
Fund D-1.7%8.5%75%
Fund E8%3%45%

It shows how different the range of returns can be over a given period as well as the ranges of volatility and gross exposure. Hedge funds are supposed to provide diversification through their asymmetrical return profiles, their ability to hedge out market risk, plus their use of leverage to enhance returns. Only looking at return numbers, without understanding volatility and gross exposure is therefore far too simplistic and results in asset allocators throwing the proverbial baby out with the bath water.

The important question to ask when selecting a hedge fund is, ‘does it do what it says on the tin’? While RisCura’s data for 2018 showed that overall funds with a long short strategy delivered a positive absolute return for 2018, the real test would be to risk-adjust these numbers as the variation of volatility is so high. Not that volatility is the perfect measure of risk, but it’s the best we have!

Hedge fund managers using a long short strategy can invest in a broad range of assets. The use of shorting and a flexible asset allocation process means the return profiles of the funds can vary significantly, hence the need for information like volatility and gross exposure, particularly over time. This would add a lot more colour for the investor or asset allocator.

A closer look at Fund E in Table A, which delivered a very strong risk-adjusted return for 2018 with a low gross exposure, reveals that this was primarily achieved with a very high cash content in the fund over time. As its mandate allows for this disperse asset allocation calls it was perfectly acceptable for the manager to implement. However, in isolation, the return number is meaningless and, hence, the need for additional data to make it more informative.

In conclusion there is definitely a place for hedge funds in portfolios, especially to genuinely diversify returns from mainstream asset classes. However, a decision to include them needs to be informed by what strategy the investor wants exposure to depending on their view of the broader market.  For example, if an investor or asset allocator feels that risk assets look attractive then a good implementation strategy (if one wants to use hedge funds) would be a high volatility, higher gross exposure long short strategy that in the past has had a much higher beta than the market. If the investor prefers non-correlated returns, then a better choice would be a market-neutral hedge fund with a reasonably consistent volatility profile and lower gross exposure.

An improved break down of how the long short ‘category’ can be interpreted and having additional information on the funds would increase investors’ confidence as, by using a different lens over time, they would be able to make better decisions.

RisCura analyses a large portion of South African hedge funds.

– George Tsinonis,
head of investment analytics, RisCura