Hedge funds may resemble unit trusts in that your money is pooled with that of other investors. However, the resemblance stops there. You should be extremely wary of hedge fund investments because they are largely unregulated in South Africa, which means you have little protection under the law and are heavily reliant on the hedge fund manager. This week, as part of our series on how to mange your money, we tell you more about investing in hedge funds.
Hedge funds are largely aimed at institutional investors and wealthy individuals. These investments are less dependent on market movements and as their name suggests, by "hedging your bets", they can offer you protection from markets that are falling. Hedge funds can be used as a means of protecting your investment portfolio or to include a level of risk management within your portfolio.
What hedge fund managers won't tell you is that hedge funds can take spectacular nosedives and you can lose significant amounts of money. The lack of regulations for these investments means that hedge fund managers can take much greater risks than unit trust managers.
You don't have to look very far for an example of how badly things can go wrong. Two years ago, the local Evercrest Aggressive Hedge Fund worth about R120 million collapsed, and investors lost about 60 percent of their money. Shortly after its collapse, regulations governing hedge fund managers were introduced under the Financial Advisory and Intermediary Services (FAIS) Act (see "Current regulations and proposed changes to the law", below).
Long and short
Hedge funds tend to invest extensively in derivatives such as futures and options (see "How to invest in derivatives", Personal Finance, May 16). They are generally highly speculative and also invest "long" or "short" in securities such as bonds and shares, depending on the direction of the markets.
Investing long means buying a share or a bond with a view to making a profit when the price of the share or bond rises.
Investing or selling short is when you sell a share or bond without actually owning it, because you believe the price will fall. When the price does fall, you buy the share at the lower market price and deliver it at the original price agreed on.
For example, the hedge fund manager borrows a share when its price is R50 and sells it on the market for that price. When the share price falls to R25, the fund manager buys the share on the market for R25 and returns it to the lender, making a profit of R25, or 100 percent.
Because hedge fund managers are able to sell short, they can make money when markets are rising or falling. Unit trust funds are not allowed to sell short.
Robert Foster, the chairman of the Alternative Investment Management Association, says naked short selling is not allowed in South Africa.
"In a naked position, offshore fund managers do not initially receive cash for the short position and therefore have no direct collateral to back their trades," he says.
Hedge funds are considered high-risk investments because managers are able to leverage their portfolios (another thing unit trust funds are not allowed to do). This means they can increase the market exposure of the fund beyond the amount actually invested in the fund by borrowing money, to increase your returns.
But leveraging also increases your exposure to potential losses. The degree to which leverage may be used in any given hedge fund portfolio is limited by the fund's mandate. You should carefully review the hedge fund mandate and the limits included in it before making an investment decision.
No public disclosure
A lack of regulation means that hedge funds do not have any public disclosure requirements. It can be difficult for you as an investor to assess the diversification of a hedge fund or its investment strategy, unless you are able to see its investment mandate.
Because hedge fund investments are unregulated, hedge funds can not be advertised or promoted in the same way a bank deposit account or unit trust fund might be advertised. You may think this would mean hedge funds were not a popular form of investment, but according to the latest Novare Investments South African hedge fund survey, the total assets invested in the South African hedge fund industry over the year to June 2008 amounted to more than R30.3 billion, or 1.8 percent of the investment industry's assets.
The average investor is unlikely to invest in hedge funds directly because of the high minimum investment amounts - usually in the region of R100 000 for a fund of hedge funds (see below) or more for a single hedge fund.
The costs of investing are also high - usually one to two percent of assets plus 20 percent of returns above the fund's high-water mark (the fund's net asset value on the day you invest).
Indirect exposure
You can have indirect exposure to hedge funds through life assurance products, although life assurance companies must ensure that you are not exposed to hedge funds unless you specifically request this exposure. Many people have indirect exposure to hedge funds through their retirement funds. You will find that it is mainly the larger retirement funds, which have enough assets to hire professional investment advisers and carry out due diligence studies, that invest a portion of those assets in hedge funds.
You can also invest in a fund of hedge funds in which the manager picks the best hedge funds to invest in and does a lot of the research legwork for you. This is a safer way to invest because an expert is choosing the funds for you. You also benefit in that your investment is diversi- fied across a number of hedge funds and not exposed to only a single fund.
The costs of investing in a fund of hedge funds are usually high because you have to pay the fees for the fund of funds as well as those for the underlying funds. However, it may be worth the additional fees to have an expert fund manager and the diversification that such a product offers.
According to the Novare study, funds of hedge funds comprised 64 percent of all hedge fund assets as at June 30, 2008.
CURRENT REGULATIONS AND PROPOSED CHANGES TO THE LAW
Hedge fund managers must be licensed under the Financial Advisory and Intermediary Services (FAIS) Act with a category IIA FAIS licence. There is no specific FAIS licence for intermediaries or brokers selling hedge funds. However, brokers can be licensed to sell you products which serve as "investment wrappers" for hedge funds, such as company shares or long-term insurance products.
If you are given inappropriate advice about investing in a hedge fund, you can take recourse against your intermediary, broker and/or hedge fund manager in terms of the FAIS Act.
All wrapped up
Jonathan Dixon, the long-term insurance registrar at the Financial Services Board (FSB), says the FSB is worried about hedge funds being wrapped in life assurance policies and sold to uninformed consumers.
"Our concern is largely around transparency, disclosure and the methods of sale. We are reviewing the sale of hedge funds within life assurance policies with a view to declaring this an undesirable business practice," he says.
The FSB, together with the hedge fund industry, is working towards the regulation of hedge fund investments and is also reviewing other legislation which could contribute to the regulation of hedge fund investments in South Africa.
In July last year, a board notice published by the FSB made it compulsory for hedge fund managers to provide a "risk disclosure notice" when selling hedge funds. This is in addition to the risk disclosures required in terms of the FAIS Act.
Since hedge funds are not often sold directly to investors, the hedge fund manager has to give the risk disclosure notice to the intermediary or broker, who is then required to pass the information on to you before you invest in a product which includes hedge funds. In addition to the generic risk schedule published in the board notice, fund managers are required to include any risks specific to the hedge fund you are investing in.
According to Regulation 28 of the Pension Funds Act, retirement funds are not allowed to invest more than 2.5 percent of their investment portfolios in "other assets", and hedge funds typically fall into this category. But investment companies have been using special-purpose vehicles - such as companies or limited liability partnerships - to market hedge funds and to get around the 2.5 percent limit imposed by Regulation 28.
Amendments
Proposed amendments to Regulation 28 might mean that these special-purpose vehicles are treated on a "look through" basis when the FSB is testing compliance with regulations. This means that if there are any hedge funds in an investment package, that percentage will have to be included when calculating whether the alternative investment exceeds the 2.5 percent limit.
Regulations being drawn up by the FSB are likely to include a recommendation from the industry that the administration and valuation of hedge funds are totally independent from the hedge fund manager in order to minimise the potential for fraud.
According to the Novare Investments South African hedge fund study of 2008, the administration of 88 percent of hedge fund assets is already outsourced to third-party administrators and 90 percent of newly launched hedge funds are also outsourcing their fund administration. All newly launched hedge funds in South Africa are using independent auditors, according to the survey.
STRATEGIES USED BY FUND MANAGERS
The two main strategies employed by hedge fund managers, with different levels of risk, are:
- Long-short equity strategies.
This involves buying assets you think will increase in price (going long) and selling assets you don't own in the belief that their price will fall and you will be able to buy them for a lower price later (short selling); and
- Market-neutral strategies.
Fund managers maintain a balance between long and short strategies. The fund manager can make money on good share selections regardless of which way the market goes. For example, he or she may be long on the shares of bank A and short on the shares of bank B. In this way, the fund is not exposed to the market risk that traditional investors in these shares would face. The fund has limited its exposure to the movement of the share of bank A relative to that of bank B. The risk is tied to the positions taken and can vary from low to high.
Other strategies that are typically incorporated as part of the two main strategies above are:
- Arbitrage strategies.
Fund managers look for and take advantage of inefficiencies in the market. Arbitrage involves the simultaneous purchase and sale of related or similar assets to profit from a primary discrepancy. For example, there may be a difference between the prices of the shares in a holding company and the shares in its subsidiary. A manager using this strategy sells the overvalued share and simultaneously buys the undervalued share. This is usually a low-risk strategy;
- Event-driven strategies.
Hedge funds can take advantage of events that produce returns independent of market trends. For example, they may exploit price differences that arise when companies merge or new companies list or a company restructures; and
- Global asset allocator funds.
These funds invest in a range of asset classes and can use very high leverage, making them high risk with potentially high returns.