Alfred W. Jones is generally believed to have been the first to refer to his strategy of buying shares and hedging the positions with short sales as a hedge fund, in 1949. The idea is that one could potentially benefit from both rising and falling prices.
For those unfamiliar with the practice of short sales or shorting a company, it can be explained as follows: it is a normal buy low and sell high transaction in reverse. You sell high and then buy low. To accomplish this, the investor borrows the share from another investor that already owns it and then sells it in the market. If the price of the share falls, the investor buys the financial instrument and returns the shares to the original owner. In this way, an investor can benefit from falling prices in a share.
Since those early days, hedge funds have grown to an industry with more than $3 trillion assets under management (AUM). Initially, hedge funds were only accessible to the ultra-wealthy and institutional investors, but over time they have become available to the general investment public.
In general, hedge funds aim to generate returns that are uncorrelated with the broader market and are therefore classified as alternative investments. Hedge funds pursue a variety of different strategies to achieve this goal. The four most popular being:
- Long–short equity: buying or “going long” and short-selling or “going short” shares
- Event driven: attempting to position the hedge fund to benefit from a specific event, like the unbundling of a company
- Macro: trying to position the hedge fund to benefit from macroeconomic events
- Fixed-income arbitrage: attempting to benefit from mispricing between various fixed income instruments.
Most hedge funds will also use gearing. This refers to using borrowed money while investing and amplifies both profits and losses. The motivation for using gearing is that the profitability of some strategies is low and, in order to make it a worthwhile investment, gearing is implemented. It is a powerful tool, but must be used responsibly and conservatively.
As is evident from the above, hedge funds try to generate returns in non-traditional ways while taking similar or less risk than traditional methods.
The low correlation with the broader market can offer diversification benefits to an existing portfolio, resulting in lower overall return volatility (risk) for the combined portfolio at a similar or higher return potential.
Investments into a hedge fund are managed as one pool of funds, hence all investors in the fund receive the same risks and returns. In South Africa, hedge funds are regulated as a collective investment scheme (CIS). The differentiating factors between hedge funds and other collective investment schemes is the ability to use gearing and go short of financial instruments.
Returns generated in a hedge fund are of a capital nature if the investment is held for three years or longer and performance fees are payable relative to a benchmark.
Here then, is a summary of some characteristics of hedge funds in South Africa:
- They offer specialist investment strategies
- Returns are generally uncorrelated to market returns
- Short selling and gearing are used in the investment process
- They are managed as one pool of funds
- There is no lock-up period, but longer investment periods are beneficial
- A performance fee is payable if returns exceed the benchmark
In South Africa, there are three vehicles that can give an investor access to hedge fund exposure, namely a qualified hedge fund, a retail hedge fund, or a private partnership such as the AlQuaTra Fund En Commandite Partnership offered by Pyxis Investment Management.
The private partnership aims to profit by utilising proprietary mathematical models in its investment process. The strategy resembles the equity long-short mentioned earlier. The investment goal is to generate absolute (positive) returns in excess of short-term interest rates net of fees and only invests in liquid financial instruments. The fund is generally cash neutral (long and short positions are approximately equal in value).
The fund targets a return in excess of its benchmark which is STeFI + 3% with a high-water mark provision (i.e. performance fees are only changed on additional outperformance over the benchmark). The Short-Term Fixed Interest Composite Index (STeFI) measures the performance of Short-Term Fixed Interest or money market investment instruments in South Africa.
ABOUT THE AUTHOR:
Henk Myburgh, CFA® – Head of Research
After completing a BCom Econometrics and MSc in Quantitative Risk Management at the North-West University, Henk Myburgh (CFA), started his career in financial risk management at HSBC. He also worked at Sanlam Capital Markets, where his focus was on consolidation of financial risk across the firm and management of risk on a holistic basis. In 2018 he founded AlQuaTra, a quantitative private hedge fund.
