Sygnia’s decision last week to close all of its hedge funds has raised important questions about this industry. What are hedge funds supposed to do, and how should investors judge whether they are delivering?
In particular, many investors have been asking how you should measure their performance against traditional unit trusts. Since balanced funds are also designed to manage risk while delivering returns close to the stock market, are they directly comparable?
While this may seem logical, Werner Opperman from 27four Investment Managers says that contrasting these strategies against each other may not be entirely the right approach.
“My argument here is a similar argument to what I would say in the active versus passive debate,” he explains. “It’s not either-or. Hedge funds form part of the universe of tools you can choose from. Depending on your objectives, you can decide to use them or not.”
He points out that the value of hedge funds is not always evident in their pure performance numbers. What makes them valuable is that hedge funds offer risk adjusted returns that are higher than most other solutions.
Risk vs return
As the chart below indicates, for the five years to the end of June this year, the major hedge fund categories all outperformed cash (STeFI) and the bond market (ALBI). Their returns were however below equities (SWIX All Share).
Source: 27four Investment Managers
Roughly speaking, this is where one would expect these strategies to fall. Importantly, using their standard deviation, or volatility, as a measure of risk, the hedge funds also produced higher returns for each unit of risk they took.
While it is important to note that conflating volatility and risk has its problems, strategies that produce returns at lower volatility can be extremely valuable. When investors need to create smoother return profiles they have a big role to play.
Hedge funds can also offer meaningful diversification benefits.
“Hedge funds offer access to different strategies and hence different sources of risk premia,” says Opperman. “This in turn enhances the diversification characteristics of your portfolio. You end up with a more robust portfolio that is not reliant on pure long-only equity return. Just like you would diversify across asset classes one should be diversified across strategies in each asset class.”
That is the theory. The problem over the last few years, however, is that equity long-short hedge funds have failed to deliver this diversification. It is not just that they have performed poorly, but that they did not offer anything meaningfully different from traditional strategies.
Selwyn Pillay, chief investment officer of Sanlam Multi Manager International, says that he largely moved away from using equity long-short hedge funds because what they were offering was too similar to what he could get from traditional equity funds.
“The alpha signatures that I was buying from an equity long-short hedge fund were too similar to the alpha signatures I was buying from long-only equity managers,” Pillay explains. “I would rather spend my hedge fund allocation on alpha signatures that I can’t access in the long-only space, and those have predominantly been in fixed income, commodities and the multi-strategy funds.”
It is this more than their pure returns that hedge fund managers may need to address.
“Some hedge funds drastically underperformed because they stopped looking for new ideas and diversification strategies,” Opperman suggests.
However, there are signs that this may be changing. Although the performance of hedge funds over the last three years has been disappointing, it has improved noticeably over the course of this year.
Returns to 30 June 2018
Hedge News Africa Fixed Income Index Hedge News Africa Long/Short Equity Index Hedge News Africa Market Neutral & Quantitative Strategies Index Hedge News Africa Single-Manager Multi-Strategies Index SWIX All Share Index STeFI ALBI
5.63% 0.97% 1.95% 2.32% -4.82% 3.54% 3.97%
Source: 27four Investment Managers
While equities have delivered a negative return, hedge fund strategies across the board have managed to produce positive numbers.
Even within this universe, however, it is clear that there is a wide range. This illustrates another vital point that the debate on hedge funds has raised – that these products are not homogenous.
The more unconstrained nature of hedge funds means there is an extremely wide range of strategies they can follow. This is the other major benefit to investors – that it is possible to find risk return profiles in the hedge fund space that simply aren’t available anywhere else.
“For example, there are hedge fund strategies that can give you equity-like volatility, and equity-like returns, but invest exclusively in the fixed income space,” says Pillay. “You get zero correlation to equities, but a similar pay-off profile. This also means that you could get draw-downs of 20%. So that isn’t a capital protection-type fund, and it isn’t meant for an investor looking for that type of product.”
As hedge funds are still new to most South Africans, these kinds of nuances need to become better understood. Investors still have to become comfortable with the range of different strategies available and what they offer.
“Investors need to be more cautious and understand what they are investing in,” says Pillay. “That’s not necessarily the mechanics of the funds, but at least their risk profile.”
This will allow them to understand what kind of outcomes they should expect.
“There is also an obligation on the hedge fund industry to make this more explicit,” Pillay says. “They need to show investors how much they could potentially lose in a bad environment, and how much they could get in return. They must show the asymmetry in the investment product. That is where the retail investor needs to get more comfortable.”