Hedge funds – an unappreciated lever during volatile times

Lethu Zulu, Alexander Forbes Investments

In 2016 we began cautioning our clients about rising economic and political uncertainties globally and the impact this might have on meeting long-term investment objectives. Fast-forward to 2020, and no one could have predicted that a global health crisis would ultimately trigger fragile financial markets to the point of collapse. In the following year, we were on a stop and start where different strains of the virus tested our – and the market’s – resolve to a point where we are now living with it.

We would have been forgiven for thinking that 2022 would be a year where ‘normality’ would resume, but unfortunately, Russian President Vladimir Putin had other ideas. Having experienced the Covid-19-induced economic effects across the world and the markets, as well as in our daily lives, we then had to deal with the prospects of what could have been a war in Europe. Not to be outdone by 2020, 2022 also introduced the world to inflation levels not seen since the 80s that forced central banks to act fast and hard, finishing off what prospects of ‘normality’ we thought we would experience.

Preparation for uncertainty means being better positioned to protect during extreme conditions. The significant market changes we have witnessed in a very short time have reminded us of the benefits of asset allocation and prudent portfolio construction. We anticipated an environment of heightened volatility and lower investment returns back in 2016, and we took measures to mitigate against this environment without compromising long-term objectives. Where appropriate, introducing hedge funds into our multi-managed solutions represented one way that we had prepared to capture differentiated performance returns and protect against turbulent markets.

Reaching a decision to incorporate hedge funds into the mainstream component of our multi-managed portfolios, where appropriate, required a thorough analysis and appreciation of our investment process. The multi-managed investment approach we follow at Alexforbes places great emphasis on risk management. This is done by using different levers such as a complementary blend of asset classes, investment strategies and asset managers to reduce the impact of negative environments – giving our multi-managed solutions the highest probability of achieving our clients’ investment objectives.

Multi-management allows us to purposefully spread risk to reduce the impact of a low-return and volatile environment by deploying different investments at different times, in line with our views. We are experiencing the impact of this environment, which is expected to persist; here, hedge funds continue to have a role to play.

Tools of the trade

In our world, when we consider the word ‘hedge’, it comes from a risk-management objective to reduce losses to achieve superior performance over time. To do this, hedge funds can employ a wide array of money management strategies that allow them to generate returns in both upward and downward trending markets. The flexibility enabled by this broader toolkit of strategies is what gives hedge funds greater opportunity sets to spread investment risk and capture returns relative to traditional market-linked portfolios. Often, asset managers may employ all, or some, of the strategies available across the hedge fund toolkit. Hybrid-like hedge funds comprised of multiple strategies can improve diversification, generate smoother return profiles and growth potential.

During the past 10 years (barring the past two to three years), the equity market has largely moved up, resulting in a few deep and prolonged market drawdowns – in part, we believe, due to government intervention since the global financial crisis (GFC). The lack of deeper market downturns has optically distorted hedge fund diversification benefits since the GFC. This led some to inadvertently extrapolate the asymmetry properties of the recent past with the expected future and see no place for hedge funds. The past two to three years have shown us otherwise, illustrating the value of diversification and, even more, the importance of a hedge fund allocation, where appropriate.

The value of hedge funds

The chart below demonstrates the value of hedge funds in providing an element of protection (or hedge), more so over periods with drastic market crashes such as the 2008 global financial crisis, the recent market downturn triggered by the Covid-19 outbreak in 2020 and the inflationary risks of 2022.

Through a diversified collection of alternative risks and a disciplined risk-management approach, well-constructed hedge fund allocations have proven to inject resilience into long-term growth portfolios. The pursuit of better risk-adjusted returns requires investor patience and a long-term horizon. Hedge funds, and the underlying strategies they employ, have a role to play and have proven to be an important allocation to the mainstream component of our multi-managed solutions since their introduction. They provide adequate protection during times when markets are under pressure, while still providing positive returns when markets recover.

Like any investment, hedge funds are not without risk and need to be managed carefully. Without a proper understanding of hedge funds, their characteristics and how different strategies are expected to work in various market conditions, hedge funds can be quite daunting to new investors. 

The following are some key considerations for investors looking to cost-effectively capture the diversification benefits and performance efficiencies of hedge fund strategies:

Asset manager selection

Hedge funds tend to be more reliant on asset manager skill (successful active management), rather than the direction of the markets, relative to traditional equity and bond portfolios. The dispersion of returns between hedge fund managers can be wide, so asset manager selection is a very important consideration.

Management fees

Although hedge funds charge lower fees now than they did historically, they are still relatively higher than traditional long-only portfolios. This is primarily a result of their broader mandates, as well as the different strategies that they can employ to enhance performance returns or reduce risk. Investors should consider whether the diversifying properties and the inefficiencies available for hedge funds to exploit means that performance returns, after fees, will be achieved. An analysis of performance returns, net of fees (performance after fees are deducted), is useful in understanding the true value of allocating exposure to hedge funds.

Performance fees

Hedge fund asset managers typically charge performance fees, which are payable only if the portfolio is profitable compared to its benchmark. Performance fees provide a good tool to align the interests of the asset manager and the investor, and should be structured correctly at levels that reward asset managers for desired outperformance without encouraging undue risk-taking. To ensure fair treatment of all parties and alignment of interests, investors should consider fee structures that take into account a number of key elements, namely high watermark provisions (so that investors are not charged multiple times for the same levels of outperformance), and hurdle rates (the level of performance return that must be exceeded before a performance fee can be earned by the asset manager).

Access

Hedge fund investments can be accessed through single-manager hedge funds (direct investment into securities) or fund of hedge funds (investment into various underlying hedge funds). Important criteria in determining which choice to make are the time and resources required to spend on the investment, and the likely size of an investment, as hedge funds may have a high minimum investment criteria. South African retirement funds may invest into hedge funds that meet specific criteria and are restricted to an aggregate maximum exposure of 10%.

Recipe for success

Over the years, we have developed a proven and repeatable asset manager research process that helps uniquely position our investment team to find investors the best hedge fund strategies and the top-rated asset managers best placed to implement them. Using our aggregate buying power and longstanding asset manager relationships, we have been able to negotiate competitive, fair and transparent fee structures, which are in the best interests of investors. This has helped us deliver the diversification benefits of hedge fund strategies cost-effectively and with confidence.

For portfolios that currently exclude an allocation to hedge funds, this may be a good opportunity to consider further diversifying investment line-ups. For those portfolios that presently include a hedge fund allocation, we encourage staying the course. While we hope the role of hedge funds is clear, the building blocks to success are less obvious. Managing an allocation is part art and science and far less prescriptive than many desire. Copyright. HedgeNews Africa – October 2022.

Lethu Zulu is part of the portfolio management team at Alexander Forbes Investments, where he is a portfolio manager focusing on hedge funds, African equities and specialist lifestage portfolios. He holds a BSc (Hons) in Computational and Applied Mathematics from the University of Witwatersrand. He is currently pursuing his MSc in Computational and Applied Mathematics at the University of Witwatersrand. Previously, he was part of the Sanlam Multi Manager investment team as an investment analyst focusing on specialist portfolios and a manager research analyst covering all types of strategies.