Finding the best route to access hedge funds

The revised Regulation 28 of South Africa’s Pension Fund Act has sparked renewed interest in hedge funds as an investment destination. There are pronounced differences between hedge funds and “traditional” funds, as well as different approaches to accessing hedge funds, each with their own advantages, disadvantages and costs.

It’s a complex decision but hedge funds should at least be considered as part of a diversified investment strategy.

Regulation 28 previously only allowed 2.5% to the “other” category, which included hedge funds, private equity and other alternative investments that did not fit into the other well-defined “traditional” asset class categories. In 2011 the regulations were updated to provide more detailed guidelines for the “other” category. The revised Regulation 28 now explicitly allows a 10% allocation to hedge funds with a limit of 5% to a single fund of hedge funds and a limit of 2.5% to a single hedge fund.

A hedge fund is a pooled investment vehicle, often structured as a limited partnership that aims to achieve positive returns regardless of whether the market is rising or falling. This strategy is also referred to as an absolute return type strategy. Hedge funds invest in a range of markets and make use of a variety of investment strategies and securities. One can argue that their toolset is just so much wider than that of traditional managers. Hedge funds may not be marketed to the general public and are mostly accessible to sophisticated or institutional investors such as pension funds.

When considering investing in hedge funds, operational risks are material risks to understand and to monitor and manage. More than 50% of hedge fund failures are due to operational risks whereas investment risk only contributes to approximately a third of hedge fund failures. Operational risks are risks that arise from the execution of the business functions of any entity. This is the most complex risk investors face when they allocate capital to hedge funds.

Operational risks include:
•    Weaknesses in the manager’s business and operational infrastructure;
•    Deficiencies in accounting controls and procedures;
•    Errors in the net asset value (NAV) calculation;
•    Client reporting procedures.

Compliance risk arises in situations where the laws or rules governing the industry may be untested or violated, along with the procedures and ethical standards. This risk exposes the institution to fines by regulators, civil money penalties, payment of damages and voiding of contracts.

Operational and investment risk management must therefore be conducted independently from portfolio management. This requires increased efforts regarding due diligence and ongoing monitoring on the part of investors. Specific attention should be given to the following aspects:

•    share and sector concentration risk;
•    drawdown risk;
•    leverage;
•    naked shorts;
•    gates or lock-ups;
•    liquidity risk.

Most investors typically utilise a fund of hedge funds manager to manage these risks on their behalf. A new approach that is gaining fast traction is to utilise a hedge fund platform, which manages and monitors these risks but the manager selection and investment risk is left to the investor.

Which hedge funds to invest in, and how, are important decisions for investors.

There are many hedge fund strategies available, ranging from long/shortequity funds where managers take a long position (buy) in stocks expected to increase in value and a short position (sell) in stocks expected to decrease in value; to event-driven funds that focus on opportunities created by corporate events such as mergers, acquisitions and companies near bankruptcy; to global macro funds, where managers base their view on macro-economic principles and focus on overall market trends.

We believe that investors should as a first step only consider long/short equity as a hedge fund strategy. This is not only the largest single strategy in terms of assets managed in South Africa but the universe of hedge fund managers have long track records (typically five years and longer), the strategy is less complicated than others, it is liquid (i.e. monthly liquidity) and the surprise factor is relatively low.

Long/short equity is mainly designed to reduce downside risk exposure but to maintain adequate upside participation when the market performs strongly. Long/short equity hedge funds can been seen as a more actively managed strategy than any unconstrained long-only equity mandate and are potentially the most actively managed equity strategy available for investors who wish to invest across the entire spectrum of equity-orientated investment mandates.

Approaches to investing in hedge funds

The key question is then which approach should be followed to implement a long/short equity strategy. Should the investor select a basket of single managers and invest directly into their funds, or rather appoint a fund of hedge funds manager to select the single managers on behalf of the investor? Another option is for the investor to utilise a hedge fund platform, which manages the operational risk of a pre-selected universe of single hedge funds from which the investor can select and invest into via the platform. The operational risk is therefore managed by the platform but the manager selection risk remains with the investor as advised by their investment adviser.

An investor could select one or more single hedge fund managers and combine them into a diversified portfolio of managers. This strategy is most suitable to sophisticated and educated investors as they will have to be comfortable to assess the investment and operational risks of each single hedge fund manager and will also need to have portfolio construction skills to construct the multi manager solution and performance and risk monitoring skills to continuously monitor and evaluate the total portfolio. Investment advisers could assist investors to implement this strategy. The additional fees that an investment adviser charges for these services are typically 0.1% to 0.2% of the asset size of the investment or as per a time charge basis.

Fund of hedge funds

A fund of hedge funds is an investment vehicle that invests in a number of underlying single hedge funds. A fund of hedge funds is managed by an investment manager such as a multi-manager who selects the single hedge funds on behalf of the investor. A fund of hedge funds offer investors more diversification than investing in a single hedge fund but charges an additional layer of fees for their offering. Such additional fund of hedge funds fees are on average 1% plus a 20% performance fee. Most investors utilise a fund of hedge funds approach as a first step to allocate to hedge funds. As investors become more educated they may start considering selecting single hedge fund managers with the assistance of their investment adviser.

In recent years offshore funds of hedge funds have shown a continued decline in assets as investors move their capital to single hedge funds. The capital outflows are largely driven by the growing influence of investment consultants on institutional investors, strong growth by single hedge funds and the cost or fee structure on funds of hedge funds, amongst other things. This comes as a serious challenge for local funds of hedge funds as investors are now starting to consider hedge fund platforms to reduce the total cost of their hedge fund programme.

Hedge fund platforms

Hedge fund platforms offer investors a menu of single hedge funds to choose from and to then construct their own tailor-made combination. The platform acts as a portal or gateway to all the funds approved on the platform. The platform then manages the operational risk and provides a consolidated view of all underlying investment and further acts as one point of contact for the investor. Some platforms even provide assistance with regard to the selection and blending of single hedge fund managers. A platform essentially allows the investor to fulfil the role of a fund of hedge funds manager but with the ability to make his own decisions rather than be dependent on the fund of hedge funds for manager selection. A platform also offers additional tools and services to assist the investor such as research, Regulation 28 reporting and portfolio optimisation.

A platform typically charges 0.3% to 0.5% for itsservices, which is a material saving relative to the extra fees that a fund of hedge fund manager charges. In addition, the investor will need to consider the services of an investment adviser to assist with the various decisions and ongoing monitoring of the investment. Overall, the platform approach is more cost effective than the fund of hedge funds approach.

Whether an investor selects single hedge fund managers themselves, uses a fund of hedge funds or opts to invest via a hedge fund platform, they need to make sure that the following aspects are covered by their service provider/s –

•    Operational and investment due diligence;
•    Manager selection advice;
•    Portfolio construction advice;
•    Fee negotiations;
•    Setting up of legal contract and mandates;
•    Independent performance and risk monitoring;
•    Mandate and legal compliance monitoring.

We recommend investors that wish to consider allocating to hedge funds for the first time either opt for the fund of hedge funds or the hedge fund platform approach. At least then, operational risk and compliance risk is managed on behalf of the investor as 50% of hedge fund failures occur due to these risks.

Fund of hedge funds and hedge fund platforms manage operational and compliance risk through rigorous due diligence processes and detailed daily monitoring of the underlying single hedge funds.

Every investor needs to evaluate the cost versus value-add, which a fund of hedge funds or a hedge fund platform offers. Funds of hedge funds are more expensive than hedge fund platforms but they offer a one-stop-shop solution. For the more sophisticated investor, a hedge fund platform approach may be more optimal as the investor can tailor-make their portfolio and at much reduced cost.

The role which the investment adviser plays in such a decision will firstly be to empower the investor to understand all these various approaches, thereafter to assist the investor to select the most optimal route and then, depending on the route chosen, play either a project management role or a more specialist advisory role in the implementation of the decision.

Gregoire Theron
Head of Manager Research
GraySwan Investments