Fixed income hedge funds – a rose by any name

Jeleze Hattingh, Southchester Investment Managers

In the famous words of William Shakespeare, “What’s in a name? That which we call a rose / By any other name would smell as sweet”. This quote reminds us that what truly matters is the essence of something, not just the label it carries. This concept holds true when it comes to the world of South African fixed income hedge funds, where a variety of strategies are employed under this umbrella term.

While astute investors are well-versed in the more recognised equity-related hedge fund strategies, such as market-neutral, equity long/short, and multi-strategy, there often exists confusion regarding the different fixed income strategies and their associated risks. The South African fixed income market, known for its limited liquidity especially in instruments beyond highly liquid government bonds, presents a unique landscape. Investors are familiar with the conventional risks of interest rate, credit/counterparty, and market risk. However, the subtler risks stemming from regulatory changes, leverage risk, and most importantly liquidity risk, can catch investors off guard, as was evident during the liquidity crisis of the first half of 2020 amid the Covid-19 pandemic.

Fixed income hedge funds can serve as essential diversification tools in portfolios, offering opportunities for relatively stable returns while managing risks across various market conditions. Nonetheless, like any investment, they are not devoid of risks. In this article, we will explore some of the strategies employed and investigate the range of returns within this asset class.

Firstly, let’s take a closer look at the landscape. According to data from HedgeNews Africa as of August 31, 2023, there are 14 single-manager fixed income hedge funds encompassing both retail and qualified hedge funds within the South African fixed income category. The oldest among them boasts a track record dating back to August 2001, and an impressive 13 funds have maintained a track record of five years or longer. It is worth noting that, since 2001, there have been 27 different funds at various times within this category, highlighting the survivorship bias that should always be considered when assessing the history of any fund category. Additionally, it’s important to note that the 14 funds mentioned earlier fall within the generic category, excluding three funds in the Africa fixed income (USD) category, three in the South African private debt category, and a newcomer in the worldwide flexible category.

Simplifying the analysis by focusing solely on the 14 single-manager funds within the South African fixed income hedge funds category reveals a wide range of performance and volatility profiles over time. Chart 1 illustrates this diversity, displaying the monthly performances of these 14 funds over the past five years. The chart showcases a series of waves, representing the monthly performance across various percentiles, including the maximum, minimum, 10th, and 90th percentiles. Furthermore, we include the performance of the Southchester SMART Escalator Prescient QIF fund in black, building a case for the importance of consistent returns (and the avoidance of big losses) to build a noteworthy performance over time.

Chart 2 illustrates the annualised performance over the past five years, up to August 31, 2023, plotted against the standard deviation of performance.

Standard deviation serves as a measure of the volatility that funds exhibit. The data reveals a spectrum of annualised performance, ranging from 5% to 12.9%, as compared to the annualised Repo rate of 5.4% indicated in red.

However, what is even more striking is the substantial variation in the volatility of performance across the funds.

Once again, we emphasise the performance of our Southchester SMART Escalator Prescient QIF fund, which is depicted on the same chart, providing insight into the relative risk-adjusted positioning of a strategy characterised by low volatility and consistent returns amidst the tumultuous markets of the past five years. In the words of Howard Marks from Oaktree Capital: “If we avoid the losers, the winners will take care of themselves.” And that is what is shown in chart 2.

The variance in performance, particularly the inherent volatility, is undeniably linked to the specific strategies employed by these funds. This is where things start to get intricate.

Fixed income hedge fund strategies provide investors with a wide array of options to generate returns and manage risk within their portfolios. However, each strategy possesses its own distinct characteristics, risk-reward profiles, and intricacies. By gaining a deep understanding of these nuances, investors can make well-informed decisions regarding the integration of fixed income hedge funds into their overall investment strategy. This can potentially bolster portfolio diversification and performance.

Several distinct fixed income hedge fund strategies warrant consideration:

• Relative value
• Fixed interest arbitrage
• Macro-thematic approach
• Multi-strategic approach
• Enhanced credit approach
• Leveraged spread approach

Exploring these strategies in detail can shed light on their specific attributes and help investors make informed choices to align their investment goals with the right strategy.

Jeleze Hattingh has been in the financial services industry since 2002. She holds a BSc (cum laude) in Business Mathematics and Information Science and is both a CFA and CMT charterholder. Jeleze joined Southchester Investment Managers in 2020 and jointly manages Southchester’s fixed income portfolios and investment product, specialising in the fixed income and alternative investment universe, with a focus on risk management.

The Southchester SMART Escalator Prescient QI Hedge Fund uses a highly disciplined multi-strategic approach aimed at delivering a regular and consistent return. Since inception in November 2017, the fund has delivered an annualised return of 12.3%, surpassing the Repo rate by 6.8% over various market cycles. It has earned three HedgeNews Africa awards over the past five years, recognising its exceptional risk-adjusted performance. Copyright. HedgeNews Africa – November 2023.