Henry Biddlecombe is an investment analyst at Anchor Capital.
By Henry Biddlecombe
In recent years, both the financial services industry and the Financial Sector Conduct Authority (FSCA) have worked together to make hedge funds more accessible to South African investors.
This shift represents an opportunity for retail investors to reassess their portfolios in light of their newfound access to an asset class that has demonstrated consistent and meaningful outperformance when compared to the broader equity market, and which was formerly only available to high-net-worth individuals.
Enhancing risk-adjusted portfolio performance
A core tenet of investing is that achieving returns typically requires taking on some level of risk. Without taking risk, it’s challenging to outpace inflation or grow wealth in real terms. The ideal amount of risk varies depending on your investment goals, but even a rough approximation of the right risk level can have a significantly positive impact on long-term investment outcomes.
Once an investor has established an appropriate level of risk for their portfolio – something a wealth manager can assist with – the next step is to optimise the potential returns given that risk. Simply put, there’s no benefit in taking on extra risk if it doesn’t lead to higher returns. Conversely, one should aim for the required return with the least possible risk.
It then follows that we should seek out investment solutions that earn the highest return “per unit of risk”, and this leads us to a class of funds that aims to achieve exactly that: hedge funds.
Building the optimal portfolio
To build an optimal portfolio, we rely on extensive market data. Research consistently shows that a modest allocation to hedge funds in a diversified portfolio can reduce risk (or volatility) while improving long-term returns. This is particularly relevant for the South African equity market, where volatility has been a more significant driver of share prices rather than growth in recent years.
Hedge funds are not dependent on a positive market trajectory to generate returns, and instead are able to profit from the market dynamics that conventional investment managers often refer to as “noise”. By way of example, over the past difficult five years, a South African long/short hedge fund run by the same firm that employs me has outperformed the JSE All Share Total Return Index significantly – achieving a return of 123% compared to the index’s 47% with far more month-to-month consistency.
It is the compounding effect of more consistent positive returns and smaller drawdowns that ultimately drives this divergent performance between hedge funds and the equity market, and ironically also makes them generally inherently less risky that conventional funds and portfolios (important caveat: there also exists a subset of hedge funds which are inherently more volatile and more risky than conventional funds – a subject for another day).
Re-evaluating active hedge fund strategies
Despite clear evidence that demonstrates the benefits of hedge funds, they remain underutilised across the South African investment landscape. This under-use stems from the aforementioned past accessibility issues, but also a general discomfort with the perceived complexity and risk of hedge funds.
Understanding hedge funds involves recognising their fundamental advantages:
The ability to go short: Hedge funds can profit from both rising and falling markets by taking long and short positions. This flexibility often leads to better performance in poor market conditions.
Lower risk compared to the market: Hedge funds generally exhibit lower volatility because their net exposure is often less than 100%. Many South African hedge funds maintain moderate directional exposure, capturing much of the market’s upside while limiting downside risk.
Diverse investment tools: Hedge funds employ various instruments, such as options and currency futures, to enhance returns and protect against losses.
Performance-based fees: Although hedge fund fees are higher than those charged for more conventional investment strategies, a significant portion is performance-based. This alignment of interests between managers and investors contributes to superior risk-adjusted returns.
Consider a multi-strategy fund or fund of hedge funds
Selecting a hedge fund manager can be challenging due to the diverse performance of individual fund managers. To reduce the risk of investing with the wrong fund manager, consider investing in a multi-strategy fund or a fund of hedge funds, which incorporate several strategies or managers into a diversified solution. This method is preferable to choosing individual managers yourself, as these solutions are designed to ensure that the constituent strategies are complementary – leading to more stable overall returns.
Ask for help
We often eschew the unknown in favour of the known, and when investing this can result in significant opportunity costs. This column seeks to provide insight into the historically opaque hedge fund landscape, and hopefully in doing so will lead you to make better investment decisions and to achieve an improved risk-adjusted investment outcome.
Henry Biddlecombe is an investment analyst at Anchor Capital.
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