Demistifying Hedge Funds - Seperating Fact from Fiction

• Myth 1 : Hedge funds are risky investments that often deliver poor performance

  In the past ten years since the launch of the first hedge fund in South Africa, these funds have outperformed all other asset classes. More importantly, this out-performance came with significantly less volatility. In the early years (1999 to 2001) only one fund, the Big Rock fund existed, but within the next year six more followed, no doubt attracted by the first comer's success. Today there are over 100 funds managed by 75 different managers, with over R23billion under management.

  What is more impressive however is the extent to which SA Hedge Funds have protected capital over all of the past six global crises. Especially in the past 2 years with the global credit meltdown, SA Hedge funds have provided substantial capital protection and stood up well to a very volatile environment.

  

• Myth 2 : The unregulated nature of the hedge fund industry means it is risky and open to abuse by charlatans

  Hedge funds are regulated, albeit not on a product level but on a manager level. Today all hedge fund managers in South Africa have to be licensed in terms of FAIS, with a Category 2a FSP license.

  These licenses aren't simply handed out. The "fit and proper" requirements published by the FSB, determine that hedge fund managers experience and qualifications are heavily scrutinised and need to be of a higher standard than that of any other investment manager. Moreover the FSB will from 2011 also require that hedge fund managers have larger amounts of working capital available in their businesses, to ensure operationally integrity and sustainability. These rules are again more stringent for hedge fund managers than for any other investment manager managing a vanilla long only fund. As far as a regulated structure is concerned, talks are currently on-going between the hedge fund industry and the FSB, with the goal of having a regulated product in place that would be approved and sanctioned by all relevant regulatory bodies.

  On the hedge fund side these bodies now include AIMA (Alternative Investment Management Association), ASISA (The Association for Savings and Investment South Africa) and a recently formed Hedge Fund of Fund Forum.

• Myth 3 : Hedge funds are not transparent

  Based on Blue Ink Research, in South Africa it is shown that 99% of funds use an independent author, while 85% of funds out-source their administration to an independent third party. A further 76% of funds use and independent prime broker while 96% of funds provide liquidity 60 days . Blue Ink Investments transparency risk report is provided daily and captured source provided by the prime broker. More recently the industry has seen a move towards transparency with over 86% of funds providing monthly transparency with a growing amount providing daily transparency to investors.

• Myth 4 : Hedge funds are expensive to invest in

  As with any investment product a fee is charged by the investment manager, but it is not of the level that conventional wisdom states it is. Blue Ink research shows that more than 50% of funds charge a 1% management fee and less than 22% charge a 2% fee.

  Most funds do also charge a performance fee. This is typically 20%, though it is important to note that most funds make use of a hurdle which requires them to exceed the hurdle (often cash) before any performance fee is taken. The high watermark is also practiced whereby a fund must be exceeding previous highs to charge performance fees in a fee crystallisation period. This means that in order for the hedge fund manager to charge a performance fee the returns must be positive and must exceed a certain minimum return.

  In comparison to unit trusts, the management fee charged is in line with most of the equity unit trusts, which typically charge between 1% and 2% management fees.

  Hedge funds, unlike many other investment products, report their returns net of all fees as an industry standard. This is important as when assessing the level of return versus their costs as potential investors often make the mistake of taking fees off again when analyzing the products as potential investments, thereby understating the level of return.

• Myth 5 : Because hedge funds make use of leverage, investors will often lose more than they put in

  Most investors are very concerned with leverage, but have no problem investing in property using a bond. Buying property with a 10% deposit, implies a 90% geared position, i.e. 10% long on the deposit put down plus 100% short via the debt you owe. Banks in turn can leverage their balance sheet by much more than these numbers and in the case of US banks, these levels were way higher than the 5-8 times (500-800%) gearing maintained by most SA banks when considering their CAR (Capital Adequacy) ratios.

  Blue Ink research shows that 85% of all hedge funds in SA will use leverage levels of less than 300%. The remaining 15% of funds are where higher leverage is used, generally tend to be in the fixed interest arbitrage space where the net exposures are very small and small profit opportunities need to be leveraged to harvest the opportunities.

• Myth 6 : Because hedge funds make use of short positions, they are naturally more risky than long only funds

  In a normal long only fund a manager will identify a good stock, buy it when it is cheap and sell it when it is expensive. Assuming that such a manager has skill in identifying a good stock and timing his entry, why is it not possible that this same manager cannot identify "bad" stocks, sell them when they are expensive and buy them back when they are cheap and in so doing lock in a similar profit. The opportunity set suddenly doubles!

  The hedge fund market in SA, unlike markets elsewhere, cannot make use of naked short selling. In SA a stock which is shorted has to be borrowed from a third party. This can take the form of a future's trade, a scrip lending transaction or a CFD (Contract for differences) where the counterparty will package a short sale with a long purchase and wrap the costs of the short borrowing within the product.

  Furthermore, considering the average net exposure over the past four years it would seem that while most funds employ short strategies within their funds, most will hardly ever be short on a total fund basis. In fact, our research shows that funds typically do not have overall net short positions.

• Myth 7 : Hedge funds are a threat to market stability

  One can argue that rather than hedge funds actually mitigate financial insecurities, rather than increasing them. The proliferation of hedge funds is an organic response to market needs: By buying irrationally cheap assets and selling irrationally expensive ones, they shift market prices until the irrationalities disappear, thus ultimately facilitating the efficient allocation of the world's capital.

  " Hedge funds also reduce shocks created by huge market swings, because of their capacity to wait until falls have evened out or bubbles have burst. While a common investor might pull the plug on a falling stock, a hedge fund can afford to withhold judgment, to "bet against the hype".