Despite a challenging global macro outlook, especially for emerging markets, investors are, if anything, even more positive about the prospects for hedge funds – given their ability to outperform in difficult times. Here is what they had to say in our latest hedge fund investor survey, where we polled leading allocators to the space.
Global macro factors in 2023 continue to affect prospects for investor portfolios. What is your global macro outlook at present? What can we expect from key global markets and economies?
Respondents cited a number of macro factors as being likely to drive markets in the coming period – including inflation in the developed world, continuing high interest rates, potentially over-heated equity markets in the US (at least on the technology side) and weaker than expected growth in China.
As Jacques de Kock of MitonOptimal put it: “Our view is that risk assets are under pressure globally. The bond markets globally are providing decent yields, but not without some form of risk. Picking the right areas and themes is going to be crucial.”
At the start of the year, many market participants expected a challenging time as developed market economies digested a very aggressive interest-rate hiking cycle, argued Riaan Bosch of Momentum Investments. “Market participants looked to China to offset some of these global growth concerns, yet year to date the US economy has proved surprisingly resilient while the Chinese economy has been disappointing and a headwind for global markets.”
Against this backdrop, he noted that the US equity market produced strong returns although these were mostly driven by a handful of tech stocks underpinned by the AI theme. “Looking forward, there are headwinds to further US equity market upside with pockets of the market trading close to all-time highs,” he said. “Recent positive US economic data suggests rates can remain higher for longer, which will not be supportive of further upside. Apart from growth and inflation concerns, geopolitical risks also remain, all pointing to a volatile environment with downside risks.”
Market conditions had generally been remarkably favourable throughout most of 2023 despite lingering recession expectations – at least until the most recent FOMC meeting, according to Jacobus Brink of SFO Investments. “Even after the release of the FOMC statement, markets remained relatively calm,” he argued. “It was only when [Fed chairman Jerome] Powell began speaking that the volatility seen earlier in September turned into a significant directional sell-off.”
Given the extensive money supply, the Fed’s inaccuracies in predicting inflationary outcomes and the structural changes in the US economy, nobody can be very certain about the future, Brink added: “Since market prices are rooted in probabilities, such uncertainty becomes a recipe for heightened volatility, increased risk premiums and expanding term premiums.”
He believes the Fed and its central bank peers will continue to drive a lot of the global macro moves going forward, with most key global economies already weak and inflation still uncomfortably far from targets. “Some markets have started to price in this ‘higher-for-longer’ rates scenario but we could see substantial downside from here. The only certainty at this stage is continued volatility,” he said.
Claire Rentzke of Sukha & Associates noted that interest rates may not have peaked everywhere in the world, but inflation and rates are nearer the top of the cycle than the bottom and the first rate cuts will start to emerge. “The pace at which inflation declines, the outlook for growth and the differences in rate-cutting cycles will cause divergence in markets,” she said.
Rentzke also highlighted geopolitical factors: “The division between east and west and the fight for the non-aligned middle may distort resource allocation and global growth,” she said. “This is also likely to be affected by slower growth out of China and the slower reform and transition of the Chinese economy. The US looks less poised to enter a recession now than last year but there is still downside risk especially where valuations are elevated.”
Anthony Hall of Corion Capital agreed that the past year has been dominated by inflation expectations, the reactions of central banks and the likelihood of recession. “Going forward we don’t see a change in that focus and at Corion, our outlook is very much where the consensus is at present – which is ‘higher for longer’ in terms of interest rates – as inflation remains stubbornly higher than the target,” he said. “Based on this, we expect markets to muddle along (barring any major geopolitical event) and remain neutral in terms of our equity/risk allocation.”
Elmien Wagenaar of THINK.CAPITAL noted that there was “strong guidance” from central banks globally that interest rates will stay higher for longer to bring higher inflation under control. “What further complicates the matter is that current drivers of higher inflation are different from what they were in the past decade and harder to bring under control with higher interest rates,” she said.
All of this, however, may not be bad news for hedge funds, Wagenaar argued: “It results in wider dispersion in equity markets – an environment hedge funds are particularly well geared to take advantage of.”
George Herman of Citadel believes that tighter monetary conditions will act as a headwind to consumers, earnings and eventually risk asset valuations. “Global growth is bound to remain below potential through 2024 and central banks are not about to ‘save’ markets by lowering rates as they’re still focused on managing inflation,” he said.
“Certain sectors of the equity markets ran too hard during 1H23 as the hype around AI sent a small group of stocks into a frenzy,” Herman added. “This means that equity markets have most probably reached their high points for 2023 already.
“Bond yields are adjusting to the new/old norm of positive real interest rates and have become investment alternatives again. This tough asset class backdrop during 2H23 is exactly where alternatives and hedge funds will be tested and appreciated… just like in 2022.”
Francois Cilliers said the global macro view at 2IP was not controversial at present – given the enormous uncertainty regarding slowing global growth: “It is amusing to see how many of the market’s so-called ‘consensus’ macro predictions for the year have not played out as anticipated,” he said.
That included the broader market’s softening stance on a recession in the US (and a materially cooling housing market), a softer labour market and the much-anticipated robust growth out of China resulting from its reopening – all of which had not materialised, to date at least.
Jacques du Plessis of Graphite Asset Advisory highlighted as potential trends the prospects of a US recession and a short-term market correction, followed by a Fed ‘pivot’ and market recovery.
Lebo Thubisi of Alexforbes Investments commented on the interplay between the global macro outlook and local developments in South Africa.
Alexforbes Investments’ asset allocation committee had recently downgraded the global outlook from positive to neutral owing to various factors, he said, including the global deceleration in economic growth, risks of deflation, and disappointing growth in China.
In South Africa, however, he noted that there had been some easing in loadshedding in recent months – which could support a recovery in the earnings outlook for certain sectors, such as food retailers. An inflation roll-over effect may also provide a ratings boost for banks, he suggested.
Stimulus measures from China had historically also boosted commodity prices, though Alexforbes did not expect this to have much effect in the near future.
Equity and fixed income markets have been complex this year, amid slowing growth and price pressures. What types of risks do you see currently for investors?
Respondents foresee a wide range of downside risks ahead for markets globally – and for South Africa.
According to Lebo Thubisi of Alexforbes: “The bad news is that [any] further forecast rate hikes from the Fed, BoE, ECB and RBA will continue to put pressure on the SA ‘carry trade’ and challenge the financing of SA’s twin deficits. The SA political environment could also challenge investor confidence.”
In the US, the yield curve framework is sending a recession signal, Thubisi warned – with US 10-year/three-month yield spreads, another reliable recession indicator, inverted. “Profit margins are peaking and money supply in the US and Europe keeps contracting. Corporate earnings will likely start deteriorating into the second half. Labour markets are [also] lagging indicators and could weaken abruptly.”
Anthony Hall of Corion expressed it similarly: “Downside risks remain a hard landing in terms of the magnitude of a recession (though we don’t think this is likely); inflation increasing instead of falling due to energy prices; and geopolitical events.”
For Jacobus Brink at SFO Investments, divergence has been the order of the day so far this year within both equities and fixed income markets. “There are areas of both these asset classes that offer value but with expected heightened volatility we have remained fairly conservative in our allocations to both,” he said.
“The big downside risk to both would be a continued upward trajectory in inflation, which would in turn eventually lead to slower growth as central banks try to fight it with higher rates. We can also not rule out a large systemic/credit event that would definitely rock markets.”
Jacques de Kock of MitonOptimal cited various potential risks including debt traps, value traps and geopolitical risks, as well as high valuations – a potential factor also highlighted by Claire Rentzke of Sukha & Associates.
“Starting valuations are always key,” said Rentzke. “However, cheap assets sometimes get even cheaper.”
“Global equity performance has been radically skewed by the race in AI and investor obsession in chasing the stock prices of the current leaders even higher. The current environment has many of the same characteristics of the ‘dotcom’ bubble, though it is unlikely to play out in the same way,” she predicted. “The clear downside risk is that the technology evolves in a different direction, that new players enter the arena or disruption comes from outside the sector, which sees a radical correction from very lofty valuations as earnings fail to materialise.”
She adds that global bonds look much more favourable from a valuation perspective, even though we may not be quite at the top of the rates cycle. “And there may be more downside if inflation is not reduced and brought under control quite as soon as expected,” she added.
SA bonds are offering very attractive yields and as the risk-free asset for local pension funds, they also meet the required return objectives, Rentzke argued. She cautioned: “It is tempting to not look any further than this. However, the fiscal risks remain elevated and while significant amounts of pessimism are already priced in, as we saw in May the news can get worse – and there is the potential for yields to blow out even further.
“In addition, with the flows that have gone into income funds and the demand for credit instruments, the credit spreads on offer in the market do not always compensate investors for the added risk of corporates and the lower liquidity.”
Francois Cilliers of 2IP argued that the main problem for investors is, in fact, not the uncertainty regarding global growth and earnings, but the fact that equity markets globally (the US in particular) have largely already priced in a lot of the upside. At the same time, the bond market was still “at loggerheads” with central banks regarding where rates will be a year or two from now – and as a result is lagging yet again in performance year to date.
“Whereas the local market is arguably quite attractively priced given how much bad news is priced in and how weak the rand is, the same cannot be said for the broader state particularly of developed markets,” Cilliers added, though it was important to bear in mind the associated short-term risks for EM in the case of a material risk-off event. “It is precisely this kind of market environment in which investors could potentially benefit from increased exposure to hedge.”
George Herman of Citadel agreed that global equities are somewhat richly valued as rising bond yields have not been thoroughly appreciated and processed. “There is also a large dispersion between sectors and geographies. Tech got inflated thanks to AI, whilst consumer stocks started feeling the pinch. The US and Japan gained, whilst Europe and China lagged. Many opportunities abound.”
Elmien Wagenaar of THINK.CAPITAL took up a similar theme: “In my view, the biggest downside risk for investors is to ‘wait it out’. Over the past 15-odd years, a phase of low to no returns was short lived and was followed by a sufficient recovery that ensured that mere directional exposure to bonds and equities delivered inflation-beating returns over the combined period. Now, inflation is higher, interest rates are higher and indications are they will stay higher for longer – so periods of low to no returns could easily be longer too.
“To rely merely on directional exposure to traditional asset classes (in other words the same portfolio that was sufficiently successful during the previous regime) to produce sufficient returns is a big risk.
“Hedge funds can help here,” Wagenaar concluded: “By being perfectly suited to generate returns from dispersions and unproductive volatility (price fluctuations that end up not generating returns), they can accumulate value during the periods directional exposure to bonds and equities can’t. This will result in a higher base from which the directional exposure can grow when their time comes. This combined approach has a higher probability of generating inflation-beating returns.”
Which asset classes offer upside for investors in the current climate? Should hedge funds be part of the mix?
More investors were positive about South African fixed income than equity market opportunities at present. Not surprisingly, however, nearly all were positive about prospects for hedge funds.
“SA equity is currently very cheap relative to its history and given the level of free cash flow and dividend yields,” said Claire Rentzke of Sukha & Associates. “There are currently some very attractive opportunities for generating returns even if the market continues to go sideways.”
This was not without risk though, she warned, as the cost base for many local companies had grown significantly with higher inflation and growing energy costs. In addition, the consumer was under increasing pressure from the escalating cost of living and reduced purchasing power.
“Foreigners have abandoned the local market, reducing liquidity especially in the mid- and small-cap sectors,” Rentzke continued. “While things only need to improve marginally for an uplift, the risk still exists that things continue to get worse for local companies. In addition, with local bonds at such attractive yields, there is little compensation for investors to take on additional risk through allocating to equity – with bonds providing compelling inflation-beating returns.”
SA bonds offer exceptional yields and with the SARB at the top of the interest-rate cycle, the outlook should be good for the local bond market. She added: “Foreigners have been net sellers, putting the bond market under pressure – but could return if the fiscal outlook improves.”
Globally, equities have been very strong over the last decade. But the performance has been concentrated and there are still sectors and regions that offer upside because they have remained cheap, Rentzke also argued.
“Reforms and a return to real interest rates and inflation make Japan an interesting possibility,” she suggested. “Emerging markets also offer a host of possibility for revaluation. Investors need to be selective as there are also risks and China is a key one.”
She noted that hedge funds offer many opportunities to go long the opportunities and short the risks. “With heightened levels of volatility, there should be opportunities for hedge funds to make money and reduce risks,” she said.
George Herman of Citadel said fixed income had become very attractive, and hedge funds should be part of the mix as equity drawdowns started appearing.
Jacques du Plessis of Graphite concurred: “Fixed income is attractive on a risk-adjusted basis. And hedge funds always play an important part in a diversified portfolio.”
Riaan Bosch of Momentum was another to highlight the fixed income side: “SA asset classes are supported by favourable valuations but face local macroeconomic risks. SA government bonds are offering very attractive yields but these include a risk premium which reflects growing concerns over the SA government fiscal position.
“The equity market, which has been impacted over recent years by loadshedding and growth concerns, also offers upside from these levels if companies can generate expected earnings in a tough operating environment,” Bosch went on. “Hedge funds are both able to extract returns from the opportunities across these asset classes, as well as offer protection and diversification given the heightened uncertainty.”
Jacobus Brink of SFO said that in the current environment, short-duration fixed income offered attractive yields to investors – with some yields outstripping the equity risk premium in certain geographies. But in an uncertain macroeconomic environment, hedge funds were perfectly positioned to add diversification, downside protection and, in some cases, even ‘crisis alpha’ to investor portfolios.
“Our portfolios have a core holding in hedge funds for exactly this reason as we believe they should form a part of any balanced portfolio,” he said.
Based on Alexforbes’ current asset allocation framework, Thubisi noted that SA and EM equities were the asset classes showing the most value, with a moderately positive recommendation. On the fixed income side, it also held a moderately positive recommendation in global fixed income, SA nominal bonds and EM sovereign bonds.
“We follow a multi-managed investment approach that places specific emphasis on risk management,” he said. “Hedge funds agree with both our objective as a multi-manager, which is to provide investors with superior risk-adjusted returns over time, as well as our investment philosophy, by allowing access to alternative return streams independent of traditional capital markets.”
Elmien Wagenaar of THINK.CAPITAL said hedge funds were crucial as part of a diversified portfolio, providing the highest probability of generating inflation-beating returns. “These funds are now readily available to a wide range of clients through platforms,” she said. “Their ability to generate returns independent of market direction at low variability will, in my mind, be the single most valuable addition to a portfolio, especially if a client is in need of regular cashflows.”
Anthony Hall of Corion agreed: “Hedge funds should definitely be part of the mix in any environment due to the varied tools of the trade that hedge fund managers can utilise.” Leverage and shorting were the main two high-level tools, which are not available to traditional long-only managers but can be used in a risk-on or a risk-off scenario.
“It is precisely this kind of uncertain global market environment where an allocation to hedge makes most tactical sense,” argued Francois Cilliers of 2IP. “Fortunately, at this juncture a lot of the domestic bad news is already priced into local valuations, which are actually not that unattractive.
“However, as in the case of a material developed-market risk-off event, emerging markets will also likely suffer even more extreme volatility.”
In that regard, it would depend on what kind of hedge exposure an investor held as to whether or not that could help cushion volatility, as some more aggressive strategies may also be more highly correlated with market moves.
Hedge fund returns are positive this year, with the HedgeNews Africa South African Single-Manager Composite adding a median 5.76% to the end of August. Are you satisfied with the way hedge fund managers are performing?
Investors were generally quite satisfied with hedge fund performance in the first half of 2023 and happy with the way the industry managed the market volatility, though not without considerable dispersion in the range of performance between individual funds.
Elmien Wagenaar of THINK.CAPITAL said hedge fund returns tend to remain diverse – and hence the satisfaction of each investor will depend on the actual portfolio they hold: “But the lower volatility with which hedge fund returns were typically generated adds significant value, especially to investors having to draw from their portfolios,” she argued. “The additional source of return ensures a more robust portfolio that is less reliant on history to repeat itself for capital to grow.”
Anthony Hall of Corion put it as follows: “As with most things in life, there will always be the outperformers and the underperformers, and this is no different to the performance of hedge fund managers this year.
“Generally, we have been satisfied with the hedge fund managers with more conservative mandates and have been slightly disappointed with the managers that can take on risk,” he went on. “The current market has offered massive dispersion between returns of underlying assets, which is normally an environment where hedge fund managers can excel.”
Various respondents, including Jacques du Plessis of Graphite, highlighted how managers in general had done well in managing downside risk in the equity market.
George Herman of Citadel put it like this: “Hedge funds have not been as stellar as during 2022, but their conservative 1H23 returns attest to their defensive positioning. This is bound to pay off handsomely during 2H23.”
Riaan Bosch of Momentum agreed that, broadly speaking, the hedge fund industry had performed very well over recent years in a challenging beta environment. “Most funds were able to deliver superior returns across the risk spectrum when compared to traditional asset classes,” he said.
Jacobus Brink said SFO was generally happy with performance so far this year, adding: “We don’t necessarily include hedge funds in our client portfolios to always outperform markets but more as a risk management tool that is positioned to take advantage of certain scenarios playing out.”
For Francois Cilliers of 2IP hedge funds, in aggregate, had not fared badly over the last year – some have disappointed and several have done exceptionally well. “I am, however, most impressed by the longer-term consistent performance of some of the hedge fund-of-fund strategies,” he said.
Lebo Thubisi of Alexforbes Investments notes that protecting capital during periods of market weakness allowed that capital to be reinvested at cheaper prices – and thereafter better returns could be expected. “Returns do not occur in a straight line,” he said. “Downside volatility will create higher return expectations again in the future. Asset allocation is needed to spot these opportunities, and a nimble and flexible approach is equally required to get to market and capture those opportunities Additionally, it’s very important not to chase returns in the current environment as this can result in even bigger drawdowns. Calls along the way must stay grounded on sound judgment.”
“Considering the changing landscape, we advise enhancing communication with clients. It’s important to guide clients towards a more realistic understanding that achieving investment objectives may require a bit more effort compared to historical trends. This implies a greater focus on saving and setting more balanced expectations for investment returns.”
But respondents were not uniformly positive about performance. “The long/short (long biased) sector has performed well,” said Jacques de Kock of MitonOptimal. “But in my opinion, the market-neutral space has not performed as it should, particularly during May 2023.”
Claire Rentzke of Sukha & Associates noted that markets had been exceptionally volatile and global markets specifically came with the added currency volatility that local SA investors face. “However, with interest rates at all-time highs and cash having delivered 7% (with very little volatility) the case for hedge funds over the past year has been much harder to make,” she said. “Some income funds have delivered twice the return of the median hedge fund over the same period at a fraction of the volatility and a fraction of the cost. There is, however, a high level of dispersion within the hedge fund universe. Not all funds are the same and they haven’t all delivered the same returns.”
Which hedge fund strategies offer the most potential in current market conditions, and why?
Long/short equity continues to be the largest category for hedge funds in South Africa and clearly still very popular with investors but, if anything, there has been a slight tilt in preferences towards lower-beta market neutral as well as fixed income and multi-strategy approaches on the latest survey.
Those continuing to favour long/short equity include Jacques de Kock of MitonOptimal, who argued that they “just have more scope to express manager skill and capabilities”, while others cited their benefits due to the dispersion in stock returns.
Claire Rentzke highlighted active managers in general: “As usual, it is those funds that use the full array of opportunities available to them that have the most potential. As the market is currently more volatile, there is more dispersion in returns and the environment is changing rapidly.
“Those managers who are active and exploiting numerous sources of return are likely to do better in a dynamic market,” she said. “It does not appear to be the kind of market where you can just be long or short the index and make money.
“Additionally, there doesn’t seem to be a one-way bet in the direction of interest rates globally. The market is being buffeted by sentiment as it fluctuates and the increased pace of news flow means that this sentiment can shift wildly. On the long-only side, investors need to look through the short-term dislocations and take a much more long-term view of where value lies. But in the hedge fund space, this is where managers who can be dynamic can make money.”
Elmien Wagenaar highlighted fund of fund strategies with the flexibility to subtly readjust allocations as opportunities arise, as well as lower-beta equity long/short and less directional fixed income approaches.
Momentum’s Riaan Bosch favoured fixed income for the current environment, noting that fixed income arbitrage can take advantage of relative-value opportunities on a steep yield curve and position for a change in the interest-rate cycle.
George Herman also highlighted fixed income as well as multi-strategy for the current market, while Graphite’s Jacques du Plessis favoured fixed income in the short term due to the high rates and the potential for rate cuts. Du Plessis also cited commodities, which “can be very attractive due to mispricing in the market”.
“With the current uncertainty in global markets we believe that a multi-strategy approach can add value,” said Jacobus Brink of SFO. “As volatility increases, strategies across the spectrum will be able to exploit opportunities as they arise, whether it be fixed income arbitrage or equity-centric.
“As we believe there is a non-zero probability of a systemic event, and with rates at more normalised levels than we have seen over the past decade, some other strategies like trend-following CTAs could also make sense.”
Lebo Thubisi was also favouring a multi-strategy approach. “Hedge funds aim to achieve positive returns at a reduced level of risk,” he argued. “Characteristics making hedge funds unique include the use of various strategies including derivatives, short selling and leverage to perform well in both up and down markets.
“While hedge funds invest in the same asset classes as traditional unit trust funds, they can take advantage of this diverse toolbox and thereby generate other sources of return. They typically show low correlations with conventional stock and bond portfolios, making them a valuable diversification option.”
2IP’s Francois Cilliers said the easy answer would favour more defensive strategies on the global equity side – and something similar or more balanced domestically, both in equities and fixed income. “But the better way to approach one’s allocation is possibly to look at how it complements the rest of your portfolio, rather than flick-flacking based on an uncertain market view,” he said.
What do you look for when allocating to a hedge fund manager, and what will cause you to redeem from a manager?
Not surprisingly, perhaps, many investors cited similar things they look for in a manager – as well as what causes them to redeem.
“It is a bit of cliché as by now almost everyone likely says the same thing, but it is a cliché because it is true,” said Francois Cilliers of 2IP. “One looks for a distinct investment management style that provides relative predictability, executed well and with persistence over time.
“Some call this investment skill and others call it talent in conjunction with long-term outperformance,” he went on. “But a manager must be able to clearly articulate what they do and do it in a predictable pattern over time so as not spring any out-of-character surprises on investors, particularly during times of market duress.
“I believe that one of the primary reasons for redemptions on the basis of performance is when a strategy was either misunderstood by investors, or when the risks were not adequately communicated by the manager.”
Lebo Thubisi noted how the Alexforbes Investments’ manager research team assesses managers based on a four-factor framework – idea generation; portfolio construction; implementation; and business management – plus a rating of the environmental, social and governance and active ownership practices assigned to all managers. “We believe that the four factors encompass the qualities that an asset manager should possess, to have strong prospect of outperformance.”
Jacobus Brink of SFO highlighted a comprehensive due diligence approach that focuses on the investment management as well as the operational aspects of any potential manager: “We believe a consistent, repeatable process and philosophy and the implementation thereof to be the most important consideration when allocating to a manager.
“Failure to implement the above along with concerns around operational aspects would prompt us to reconsider our allocation,” Brink added. “If you have a good understanding of what the manager is trying to achieve and how, performance should never be a surprise and hence a reason to redeem from a manager.”
Others highlighted more specific points, such as Anthony Hall of Corion, who cited passion, track record and risk philosophy. “A redemption will generally occur if we feel that the passion is missing and/or the manager has not stuck to their investment philosophy and process,” he said.
“[We look for a] stable team and a repeatable process with a good long-term track record,” added Riaan Bosch of Momentum. “Any unexplained deviation from the process, returns outside our expectations or key-man events can trigger a redemption.”
George Herman said that Citadel seeks out specialists in specific strategies – and redeems where it sees style drift.
“We look for attractive risk-adjusted returns during all market cycles,” said Jacques du Plessis of Graphite, “and redeem when there is sustained underperformance or change in the management team.”
Decorrelation and a structured and repeatable process were key for Jacques de Kock of MitonOptimal. “We would redeem were we see: a move away from core competency; changing strategy; changing managers (maybe); flip-flopping on views; or no conviction in portfolios.”
“First and foremost, we want hedge funds that are different to what is available on the long-only side or through a passive strategy,” said Claire Rentzke of Sukha & Associates. “The hedge fund manager must have an investment process that differentiates them, is well thought out, understands the varying nature of risk and can be well articulated.
“We look for hedge funds that have a demonstrable track record of adding value through time,” she went on. “We look for funds that have experienced, stable teams. The fund must complement the existing strategies that are in place, whether that is through return enhancement or risk mitigation.
“We would redeem from a manager who failed in managing their risk, who continued to deliver sub-par returns over multiple periods and where a key person left without properly managing succession risk.”
What types of hedge fund strategies would you like to see come to market in South Africa?
The South African industry continues to be dominated by equity long/short, market neutral, fixed income and multi-strategy approaches, and various respondents are happy with the existing range of strategies available.
Nevertheless, some said they would welcome new types of funds to expand the industry into other areas.
“Equity long/short, fixed Income arbitrage and equity market-neutral are well represented in the local market,” said Riaan Bosch of Momentum. “[But] strategies focusing on other asset classes like commodities, currencies and volatility would be interesting to see.”
Anthony Hall of Corion Capital was another who would welcome more CTA-type trading strategies, commodity strategies and global macro.
George Herman of Citadel said he would like to see more fixed income-focused, as well as global and retail-focused funds, while Jacques de Kock of MitonOptimal called for new funds focused on special opportunities.
“We have seen a handful of quantitative, machine learning strategies pop up of late, which is exciting as there is definitely a future for these irrespective of the market in which they are applied,” added Jacobus Brink of SFO. “Some more of these strategies could be interesting.”
Lebo Thubisi outlined the potential for new funds across a variety of areas, including tail risk hedging, event driven, activist, global macro, distressed debt and credit trading.
Tail risk hedging strategies, Thubisi pointed out, might protect against extreme market moves: “This strategy is expected to protect in a bearish market environment,” he said. “It would be welcomed [given] the consensus that we are currently experiencing late economic cycle dynamics.”
Event driven and activist funds could enhance corporate governance, thereby prompting companies to achieve better ESG scores, Thubisi also argued, while global macro and managed futures strategies offer significant benefits for a complete portfolio, starting with diversification. “They have no inherent long or short bias – which results in low correlations with traditional asset classes,” he added.
Distressed debt funds also often have low correlations to the market, Thubisi pointed out, as the catalyst of their return is based on the turnaround of individual companies, which are often not tied to broad market movements and sentiments.
Is the South African industry making progress on ESG (environmental, social and governance) factors?
Various respondents felt the industry has been making some progress in relation to ESG, while some felt there was no progress, mainly because it was arguably less of a headline issue.
“I believe we are [making progress],” said Elmien Wagenaar of THINK.CAPITAL. “Although it is hard to measure impact, it does not mean it is not there. And it does not mean that many industry players behind the scenes are not doing immense good. Sometimes doing good makes more sense where it cannot be measured – where it is done for the sake of impact and not the sake of measurement.”
“Hedge funds are particularly well placed to have a positive impact on governance,” argued Riaan Bosch of Momentum, “through company engagements and the ability to express both positive and negative views through fund positioning.”
Lebo Thubisi noted how Alexforbes Investments’ manager research rates all managers against a set of evidence-based ESG metrics. “At a minimum, we seek to establish whether ESG has been incorporated in the investment process,” he explained. “We also conduct specific responsible investing due diligence to ensure that appropriate time and attention is given to ESG.
“Over the last five years, we’ve seen an industry-wide incorporation of ESG into the investment process, which at the start supports the risk management framework,” he went on. “We’ve also observed, through the evidence provided, that some managers have progressed to being more active participants with regards to proxy voting and active engagements with boards of companies.
“The next frontier we believe is one where reporting requirements will intensify for managers to provide evidence of the outcomes of decisions they’ve taken in relation to ESG considerations.”
Jacobus Brink of SFO offered a different take on the issue: “No study has proven that ESG causes higher returns, and recent research has called into doubt the link between ESG and outperformance,” he argued. “ESG ratings don’t measure a company’s impact on the Earth and society, they gauge the potential impact of the world on the company and its shareholders.”
That said, Brink felt the local industry had indeed embraced some key elements of ESG to a considerable degree: “The South African industry has shown a real commitment to social impact investment opportunities and, in this instance, is moving in the right direction,” he said.
“ESG is a complex field,” added Claire Rentzke of Sukha & Associates. “There are those managers who have developed a good understanding of this space, while others still only skim the surface at best and, at worst, pay only lip-service.
“I still feel that the hedge fund industry doesn’t fully appreciate the risks that not pricing in externalities carries and that they don’t fully hold company management to account,” Rentzke explained. “We still see too many excuses from managers when things go wrong.”
Is the South African hedge fund industry making progress on transformation?
As with ESG, most respondents felt progress was being made with transformation in the local industry, although for some, it was slow.
Lebo Thubisi outlined the Alexforbes Investments’ approach in this area, which he said “has and continues to support transformation in the asset management industry, which is key to a sustainable and competitive investment management industry in South Africa.
“We also believe in the development of core skills across the industry. All managers are selected based on merit and vetted through our manager selection criteria,” he explained. “However, it’s the strategic intent and implementation of our transformation policy that has led to an increased allocation to majority black-owned managers, who satisfy a competitive advantage that meets our requirements in asset allocation, strategy selection and ongoing investment management activities.”
“The lack of industry growth has negatively impacted these initiatives,” argued Riaan Bosch of Momentum. “But some large managers have programmes in place to develop the next generation of talent.”
“There are a number of new and even established managers that have done a lot to nurture and guide new talent on an equal opportunities basis,” agreed Jacobus Brink of SFO.
Do you invest in private debt/credit and what is the opportunity set?
A number of respondents do not invest in this area, or at least not yet.
“We have a distinct preference for strategies that offer liquidity and transparency, which makes the private space trickier to access reliably,” noted Francois Cilliers of 2IP.
But there was a clear majority who expressed enthusiasm for private credit/private debt as an area of opportunity.
“The Momentum Alternative Investments programme includes private debt/credit,” said Riaan Bosch. “Increased banking regulations after the GFC resulted in reduced banking activity, which was taken up by these funds. The outlook for this strategy remains positive as investors are able to access excellent yields across market segments.”
“The private credit space has grown a lot recently,” said George Herman of Citadel. “There are more opportunities; more diversification; less exposure to government and SOEs; and improved governance,” he argued.
Lebo Thubisi highlighted various attractive aspects of the space. “Investing in private debt has several benefits, including diversification of holdings; predictable payments that generally are self-liquidating; additional legal protections; diversification benefits; yield enhancement; and low-risk investment opportunities compared to other alternative asset classes.”
Claire Rentzke of Sukha & Associates noted the wide range of opportunities in the private debt space, given that there is a large segment of the economy that the banks will not lend to, or simply charge too much to lend to, because they don’t understand the businesses operating there.
“The sector does not come without risk, and understanding the complexities and the risks is key,” she also stressed. “There is access to many more sectors and businesses than in the listed market, and yields can be attractive. The opportunity to invest in the real economy and the expansion of the economy and job creation is massive.”
Do you invest in private equity and other alternatives? What do these asset types have to offer within a broader alternative asset allocation?
Only a small proportion of respondents – just under half – invest in private equity and other alternatives as well as hedge funds. A number noted that such allocations were simply not permissible under their current mandates.
But there was also plenty of enthusiasm for the private equity space. “This sector offers the ability to allocate to businesses that are in other sectors where you don’t get exposure in the listed space, and this can offer the benefit of additional diversification,” argued Claire Rentzke of Sukha & Associates. “There is the ability to have an impact and foster job creation, but also generate commercial returns while improving infrastructure and uplifting communities.”
“As the underlying return drivers of these strategies differ from more ‘traditional’ equity and fixed income centric strategies, they do make sense as part of a broader alternative asset allocation,” agreed Jacobus Brink of SFO.
“Each of the alternative investments provide access to opportunities not available via traditional investments,” added Riaan Bosch of Momentum. “In the case of private equity, investors can access different parts of the capital structure in companies across the size spectrum. Private equity funds also play a hands-on role to drive growth in companies and generate returns for investors.”
“As part of our overall exposure to alternatives we also have investments in private markets,” said Lebo Thubisi of Alexforbes Investments. “The past few years have taught us that the world is an ever-changing and uncertain place. From unprecedented pandemics to geopolitical conflicts, global events have increased volatility in financial markets.
“Navigating these turbulent waters requires specialised knowledge and dynamic strategies to help steer investment portfolios through complex and ever-changing markets,” he added. “In the realm of investments, hedge funds and private markets can broaden the range of investment opportunities, add diversification benefits to traditional portfolios and protect in down markets.”
However, some respondents still expressed a preference for strategies focused on more liquid markets. “We believe that both liquidity and transparency remain of paramount importance and these factors are not typically readily available within PE and other alternatives, despite artificial attempts to facilitate the former – such as via listings,” said Francois Cilliers of 2IP.
“We want the price of our investments at any point to accurately reflect the current market value of the underlying investments,” Cilliers continued. “The underlying investments must have market depth, pricing transparency and liquidity. Structures should have proper investment rigour in terms of complete independence of reputable third-party service providers in all respects – which, in our view, is rarely the case locally with PE and unlisted property.”
In your view what is the optimal blend of alternatives – including hedge funds, private equity, private debt etc – in a broader investment portfolio?
Participants suggested a variety of ideal allocation levels for alternatives in a portfolio, but generally in a range of 10-30%.
“There is no single answer as risk budget and liquidity requirements determine this,” said George Herman of Citadel. “However, in broad terms, we’d see this proportion as between 15% and 25% of a portfolio.”
“Based on our experience and portfolio construction thesis, our current exposure to broader alternatives is approximately 10%,” said Lebo Thubisi of Alexforbes Investments. “Optimally, the exposure will range between 10-15%. Globally we see that exposure to alternatives being between 20-30% and in some instances higher, based on the mandate type.”
Corion’s Anthony Hall said this was dependent on the risk profile and target return of the underlying investment product. “However, alternatives offer great risk/return characteristics that traditional asset classes don’t often offer – and, as a starter, in any portfolio with a target return of inflation plus 3-5%, a minimum of 20% could easily be allocated to alternatives.”
At the higher end of the spectrum was Jacobus Brink of SFO: “We believe that a substantial portion of investor portfolios should be allocated to alternatives, but it remains mandate dependent,” he said. “As we operate in the ultra-high-net-worth space, clients do have more of an appetite for these strategies. We believe the optimal allocation to alternatives to be around 40% of client portfolios with hedge funds being the majority, followed by private equity and real assets.”
Allocations were “completely reliant” on portfolio objectives, said Riaan Bosch of Momentum. “When constructing a portfolio, the contribution to returns and the diversification benefit of the alternative strategies should be balanced against liquidity requirements and fee sensitivity of the investor. Alternative investments continue to provide investors with diversification and access to alternative risk and return sources.”
Going into more detail, Claire Rentzke of Sukha & Associates noted alternatives are not a homogenous bucket, and so the risk and return profiles of the various investment opportunities need to be understood, as well as the correlations to other asset classes and the liquidity impact.
“Private debt offers the feature of early cash flows – and of being self-liquidating, which can work well to reduce the depth of the private equity J-curve,” she continued. “The initial investment periods can be a drag on returns as capital is deployed. But this can be offset if the hedge funds are delivering good returns during that phase.
“Each opportunity needs to be assessed on individual merit, but also with the correlation to other investments in the portfolio,” Rentzke continued. “And the impact of potentially higher fees in these alternatives needs to be ameliorated by enhanced returns and lower fees in other areas.”
Francois Cilliers of 2IP stressed that the optimal blend of alternatives is dependent on the client’s risk profile. “Regardless of whether one has a 10% allocation or a 30% allocation in your broader investment portfolio, it is always important to know what you hold and why you hold it,” he said. “We don’t believe that private equity and/or debt are suitable for all investors unless accessed via a structure which provides liquidity and proper transparency. But for certain pension fund investors, that might be a lot more appropriate.”
Elmien Wagenaar of THINK.CAPITAL noted that private equity, private debt and hedge funds extract returns from different sources, so a blend should result in a more robust portfolio. “But to determine an optimal blend, the client’s circumstances and risk tolerance should be considered,” she stressed.
“Although the main sources of return are different, private equity and debt share two characteristics – that the measured volatility is lower and that the term of the investment is typically longer, and typically with no liquidity until exit,” she continued. “In this case, the lower volatility is not a reflection of lower risk, but rather just a postponement of effect of the risk taken to the end of the term. So clients need to be able to tolerate the postponed risk, not just the lower interim variability.”
It was also important that the individual clients were able to sit out the investment time frame, as part of the return of private equity and private debt is a liquidity premium – the possibility of higher returns in exchange for forgoing the ability to withdraw capital.
“This liquidity premium is very quickly eroded with attempts to create artificial liquidity and leaves only very specific company risk to contend with,” Wagenaar added. “A pension fund may have the investment time horizon, but some individuals may not. To this end, hedge funds, with an alternative source of returns, daily liquidity and access through retail platforms, remain an excellent addition to a portfolio, even without the other two sources mentioned.”
Do you invest in both global hedge funds and domestic hedge funds? If so, does your approach differ?
Investor respondents were divided roughly evenly between those who invest both within South Africa and abroad and those that invest only within the local market.
In the latter category were allocators like Alexforbes Investments, Corion Capital, SFO, Sukha & Associates and THINK.CAPITAL. Lebo Thubisi, however, did note: “Our exposure to hedge funds is currently limited to the domestic market. But if we had global exposure our approach would not differ.”
“One’s approach should be very similar,” agreed Francois Cilliers of 2IP, “with the main difference potentially being how one accesses the strategy and how the legal and regulatory frameworks differ.”
“We only invest in domestic hedge funds,” said Elmien Wagenaar. “We are of the view that although global (developed market) hedge funds typically have the ability to protect well (and used as a complement to traditional bonds), the right combination of domestic hedge funds, exposed to emerging market characteristics, have an ability to protect sufficiently and participate sufficiently to generate higher alpha.
“The use of the right combination of domestic hedge funds as part of a client’s local allocation could generate higher return, at lower risk, leaving a full risk budget to be used on the allowable offshore exposure.”
“We have invested in local hedge funds only,” said Claire Rentzke. “While we have started looking at more opportunities offshore, it does come with much more work that needs to be done to fully understand the risks for investors as the local guard rails that we have in place here are not the same.”
Among those with both domestic and foreign allocations was Jacques du Plessis, who said Graphite invests via funds of funds in SA and via a smaller number of direct allocations offshore.
Another was George Herman, who said Citadel invests in both domestic and foreign hedge funds. “The approach differs as there are different opportunity, manager and product sets in the global space,” he added. “Our philosophy and application though is still very much the same.”
What is your outlook for the South African hedge fund industry in the next five years? In your view, what are the most pressing issues that need to be addressed?
Respondents were mostly positive about the outlook for hedge funds in South Africa, but also highlighted a range of challenges on issues ranging from regulation and tax to fees, investor education and other impediments to growth.
“I believe hedge funds will play a significant role in the portfolios of a wide range of clients over the next five years,” said Elmien Wagenaar of THINK.CAPITAL. “The most pressing issue is that Board Notice 90 needs to be changed to allow a CIS in Securities to invest in a CIS in Hedge Funds. This will allow the risk mitigation characteristics of hedge funds to be accessed by clients in most need of it.”
“The industry has grown and is still growing nicely as regulation has advanced. However, we need clarity on certain regulatory issues for the industry to grow further,” concurred George Herman of Citadel. “Right now, it feels as if we’re in limbo whilst we await the outcome of some critical issues.”
“Tax changes could kill the industry,” warned Jacques du Plessis of Graphite. However, he felt inclusion of funds of funds as traditional collective investment schemes (CIS) in line with Reg 28 could provide a big boost.
Another who foresees potential opportunity in regulatory changes was Riaan Bosch of Momentum. “We have a favourable outlook for the local industry over the next number of years,” he said. “The uncertain market environment that we expect to continue could bode well for the industry as the opportunity set for these managers to outperform increases.
“We also believe the proposed amendments to BN90 regarding hedge fund allocations could be a substantial boost. We believe the lack of investor education around hedge funds has been a major impediment to growth in the industry. But we are seeing some of the larger players start to address these issues to an extent.”
Anthony Hall of Corion was another foreseeing a positive road ahead: “We believe the outlook is healthy for the SA hedge fund industry and especially once hedge funds are allowed to be included in long-only CIS funds at an allocation based on the restrictions of current long-only funds (i.e. a maximum of 20% in a single hedge fund in a long CIS).”
“I think that the hedge fund industry will continue to grow at a modest pace as inflows pick up not only from institutional investors but also retail flows as more hedge funds are added to retail platforms,” added Claire Rentzke of Sukha & Associates.
“But costs still need to be addressed and this doesn’t necessarily mean just manager fees but also the broader costs involved in administration – manco fees, trustee fees, risk management fees,” she stressed. “These all increase the costs to investors and reduce returns. The value-add of many of these services needs to be assessed and questioned.”
Jacques de Kock of MitonOptimal also highlighted what he described as a “disconnect” between fees and performance, as well as the need for a standardised way for hedge funds to show asset allocation that is “meaningful and non-threatening”.
Lebo Thubisi of Alexforbes Investments cited the longest list of challenges ahead, ranging from the continuing need for genuine active management and flexibility from managers, to appropriate risk management and further progress on diversity, equity and inclusion.
But he foresaw continuing good opportunities ahead for the multi-manager approach: “I believe funds of funds are well positioned to provide diversified solutions to financial advisors, planners, consultants and individual investors,” Thubisi said. “The intricacies of manager research and portfolio management in the hedge fund space requires special focus and attention that can be best served by fund of funds with existing track records.”
“A lot can change in five years,” said Francois Cilliers of 2IP. “But overall we remain positive on the outlook for the SA hedge fund industry, despite the growth challenges it has faced. There are no definitive pressing issues that need to be addressed – although fees will always remain somewhat contentious. The main challenge is to provide investors with access, which a lot of the platforms are now starting to facilitate.” Copyright. HedgeNews Africa – October 2023.