Hedge funds are probably the most difficult alternative investments for the ordinary person to understand, Francois van Wyk says.
They are unconstrained investment vehicles, which means they can invest in any financial instrument in any way.
Hedge funds are usually run by an individual manager or a small team of managers, Van Wyk says, and the performance of these funds depends on the skills of that manager or of those managers. In addition, the remuneration a hedge fund manager earns is usually closely linked to the investment performance of the fund.
The objective of hedge funds is to achieve absolute (or positive) returns, regardless of the direction in which the market is moving, Van Wyk says.
There are a number of different types of hedge funds in South Africa that use a variety of different techniques, but typically hedge funds are long/short equity funds, he says.
This means they do not invest in only traditional markets - such as the share market - by buying shares, waiting for the price to rise and then selling the shares to make a profit. Hedge funds also short the market by borrowing shares and selling them when the price is high, only to buy them back and return them to the lender later when the price has fallen.
Hedge funds can be very risky or they can be very conservative, Van Wyk says. For example, some funds that are known as market-neutral funds remove the risk of investing in, for example, a stock market, by eliminating the influence of overall market movements. Hedge funds typically achieve this through the use of derivatives.
Van Wyk says the problem with hedge funds is that they are complex and therefore can be quite dangerous to the uninformed investor.
He says in the case of a typical long/short hedge fund, an investor will invest R100. The fund manager will invest that R100 in a money market account. With the R100 as collateral, the manager will then borrow R100 worth of, for example, Old Mutual shares from a large pension fund.
Hedge fund managers typically borrow shares that have become expensive, Van Wyk says.
The manager will then sell the Old Mutual shares in the market for R100 and use the R100 to buy, say, Sanlam shares, which the manager deems to be undervalued, he says.
Assume that a month later the borrowed Old Mutual shares have fallen to R90, the Sanlam shares have increased in value to R110 and the R100 in the bank has increased to R101, Van Wyk says. This means the fund manager has made a profit of R21 (R10 from the Old Mutual shares, which can now be bought for R10 less than R100, R10 from the Sanlam shares, which were bought for R100 and are now worth R110, and R1 in interest on the money invested in the bank).
But what if the market fell by 30 percent? In this case, Van Wyk says, the net profit would be R1, because of the interest made on the investment in the bank.
The short position on the Old Mutual shares would result in a profit of R30, because it would now cost R70 to replace the borrowed shares. But, he says, the Sanlam position the manager had bought would now be worth only R70, and the loss on the Sanlam shares would therefore cancel out the profit on the Old Mutual shares.
However, Van Wyk says, you could also be invested with a hedge fund manager who lacks sufficient skills and who makes the wrong call.
If, in the example above, the Old Mutual shares rose to R110 and the Sanlam shares dropped to R90, the net loss would be R19 (R10 plus R10 less R1 in interest).
Van Wyk says hedge funds are not yet regulated in South Africa and may therefore not be marketed to retail investors. Foreign hedge funds may be marketed in South Africa only if they are domiciled in jurisdictions approved by the Financial Services Board.
The advantage of investing in hedge funds is that they can provide you with diversification, because these funds' returns should be uncorrelated to those of traditional investments, Van Wyk says (see graph above showing rolling 12-month returns of local hedge funds that are not correlated with those earned by the equity market).
He says typically hedge funds earn cash plus five to 10 percent a year at low levels of volatility - between three and seven percent.
However, Van Wyk says, it is quite expensive to invest in hedge funds. Managers usually charge a base fee of two percent of assets under management, plus a performance fee of 20 percent of the positive performance, often with no penalty if the fund makes a loss.
Van Wyk says the disadvantages of investing in hedge funds is that you may invest in a fund run by a manager who lacks the required skills, or the fund may not have appropriate risk controls, which could result in it incurring huge losses.
Another problem, he says, is that there are sometimes no financial controls, and you could potentially hand over your money to a fictitious fund that sends out a few bogus statements and then disappears with your investment.
Van Wyk says you may experience difficulties in disinvesting from a hedge fund because the fund may have a problem liquidating enough assets to pay you out.
Tax is also a problem because, as an investor, you will pay tax on the trading profits made by the fund, which is not the case with unit trust funds, he says. Unit trust investors only pay capital gains on the gains they have made when they disinvest from a fund and not on the profits made each time the fund sells an asset, such as a share.
Van Wyk says if you are interested in investing in a hedge fund, it is best to leave the choice of hedge fund manager with whom to invest to a professional. You can do this by investing in a hedge fund of funds. These funds offer you access to a number of hedge fund managers and your investment is therefore diversified across a few managers.
An endowment policy is also a good way to invest in hedge funds, he says.