That’s no longer entirely true – but as with all investments, there are hedge funds and there are hedgehogs.
I’m interested in investing in a hedge fund rather than a traditional unit trust fund. My investment horizon is 10+ years. I’ve seen some hedge funds outperforming their benchmarks on a consistent basis. I understand hedge funds have more tools available to outperform the market, especially a multi-strategy hedge fund. Why are these hedge funds only reserved for a ‘select few’ and why do financial advisors shy away from these products if they are so financially rewarding?
The survival of a hedge fund is strongly dependent on the stability of its investors.
Some of the strategies applied within hedge funds have liquidity constraints, which means that should there be a run on the fund – as we have often seen during crisis periods – fund managers are forced to exit positions at losses that could lead to the destruction of the fund. For this reason, hedge fund managers often place restrictions on the withdrawal terms of hedge funds.
Hedge funds tend to work better with smaller amounts of assets under management. Once a critical mass has been accumulated, funds are generally closed to prevent them from becoming ‘clumsy’.
Hedge fund managers therefore pitch their funds to attract ‘sophisticated’ investors who generally have large amounts of money to invest, hence the high minimum investment requirements demanded for direct investments into hedge funds.
However, hedge funds have evolved and any individual can now access various hedge funds in the form of unit trusts at low entry amounts – as little as R1 000 per month, as opposed to the general R1 million required amount when investing directly with the hedge fund manager.
There most certainly is a place for hedge funds within an investment portfolio, especially when one wants to ‘hedge out’ the risk of a pure equity portfolio. As you quite rightly stated, there are also multi-strategy hedge funds that invest across various asset classes and instruments.
As with all investments, there are hedge funds and there are hedgehogs. Unfortunately, the hedge fund industry has become tarnished with cowboy-like behaviour, resulting in some major international hedge funds collapsing due to aggressive strategies.
When markets rally there seems to be a trend (or there used to be a trend) where some hedge funds started acting like long-only equity funds but with an aggressive gearing strategy incorporated. This often led to heartache and wealth destruction in the past, mainly due to investors investing based on past performance and then withdrawing once returns start moving southwards …
Within the SA space, hedge fund managers do seem more astute and mindful of preserving investor capital than some of their international colleagues.
Ironically, hedge funds were created to protect capital, especially in volatile markets, by using derivatives and should be considered as fairly conservative investments.
However, as I mentioned, they can also turn rather nasty when aggressive gearing is applied and returns turn against them, so caution must be taken when deciding on a specific hedge fund.
Hedge funds can provide positive returns in a negative market by applying efficient derivative strategies. They have much more flexibility in strategy and mandate than a normal equity unit trust. So why then the resistance towards hedge funds?
In my opinion, the following factors are some of the reasons that cause hedge funds to be viewed in a negative light:
- Hedge funds are expensive. Since the objective of most hedge funds is to provide real returns, their benchmark is generally either cash or plainly to provide a positive return. Their fee structure is notorious for the 1+20 principle. That is a flat fee of 1% plus 20% on any outperformance of their measurement/benchmark. Annual fees of between 5% and 10% are not uncommon. This is a major hurdle for investors who are fee-sensitive.
- Hedge funds have been linked to various crises in the past. In 1992 they were implicated in the crisis that led to major exchange rate realignments in the European Monetary System, and again in 1994 after a period of turbulence in international bond markets. During and after the great financial crisis (GFC) there were numerous fund closures due to the gearing effect of negative returns. Where a gearing of say 300% is applied, it means that if actual negative returns are 30%, which was normal during the GFC, the geared hedge fund return ramped up by 300% to 90% loss. The resultant run on some funds was unsustainable, leading to the destruction of large amounts of wealth. Many also believe that the hedge funds were the main culprits that led to the GFC due to them short-selling global bank stocks. During the GFC, hedge funds either made a fortune or went bust, all depending on which side of the trade they were, and this often happens during crises …
- The ‘unknown’ effect. Many investors do not understand hedge funds. Mandates of various hedge funds vary vastly, and their scope of instruments and strategies is much greater and wider than unit trusts. Hedge funds that are now available via retail unit trusts are restricted and have to abide by certain rules, one of which is to provide adequate liquidity to settle redemptions timeously. Many offshore and direct placement hedge funds still apply restrictions in terms of liquidity. Redemption periods of three months with an additional three-month notification period are not uncommon. This can be troublesome when liquidity is required by investors.
I personally think advisors are reluctant to recommend hedge funds because many of them don’t understand them and the cost factor is a major deterrent. Not many investors are willing to stomach the costs.
Financial advisors also need to be registered with the Financial Sector Conduct Authority (FSCA) for every asset class they include in their recommendations, and in my opinion many decided not to include hedge funds in their offerings and therefore did not apply to the FSCA to be authorised to market them.
Good luck with your investments, may your risks be low and your returns high!