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Sunday August 07 2022
Hedging Options for Nervous Investors: Controversial Derivative Markets May Not Be As Risky As The Bad News Indicates

Financial Mail  November 7, 1997

by Jamie LaReau, Bridge News


Controversial derivative markets may not be as risky as the bad news indicates

      After a buffeting from the recent worldwide stock market tornado investors are searching for products that offer better shelter for their savings.


      It is clear that, for those who want to tap the strongest growth in global financial markets, equity market returns have always come out tops in the long term. But investors are increasingly looking for ways to cushion their funds against turbulence.


      One such route is through products that hedge equity exposures or speculate on future financial market movements in the derivatives market. A derivative is a trading instrument valued according to expected price movements in the underlying asset.


      Many retail investors, particularly South Africans who have been isolated from international trends and who see unit trusts as their easiest and most secure option, will probably shudder at the thought of entering the controversial derivatives market.


      Media coverage has focused on large derivatives losses suffered by banks and individuals, such as last week's spectacular collapse of Niederhoffer Investments. The hedge fund company is run by eccentric Victor Niederhoffer, known for going about barefoot, his views on sex before trading as well as for notching up double digit performances for his clients. Niederhoffer's failure was rooted in his prediction that Thailand's economy and currency would recover this year. This incorrect call led to his funds shedding 45%. In addition, he bet US$130m of his funds on the US market gaining ground on Monday October 27. Wall Street in fact fell over 7%.


      But George Van, chairman of Nashville-based Van Hedge Fund Advisors, argues that the fortunes of traders like Niederhoffer do not reflect on hedge funds in general.


      Not all hedge funds are this risky. The hedge funds label is an umbrella term used to describe any investment fund that makes use of derivatives strategies. Products can range from funds that base investment decisions on stock picking - mostly of undervalued and distressed stocks. At the other end of the spectrum are funds, such as Niederhoffer's, which take big bets on macro-economic changes. Between the two a range of options exists.


      Van Hedge Fund Advisors provides useful information on a sector dominated by cagey and secretive hedge fund managers and where performance records are sparse. Its data on hedge funds shows the products can be an important alternative to the more traditional mutual funds (unit trusts).


A study by the company shows that hedge funds tend to offer greater protection during market downturns than either US equity or bond mutual funds. During the six quarters between 1989 year-end and the end of the third quarter of 1996, when the S&P 500 index fell, the average US equity mutual fund lost 23,7% and the average taxable bond fund dropped 2,5%. During the same period the average hedge fund gained 3,1%. The same picture emerges during the first quarter of this year, when average equity mutual funds slipped 1,1% and the Van US Hedge Fund index gained 1,3%.







      More recently, the Van index outstripped the underlying equity market and mutual funds by gaining 11,2% during the third quarter of this year compared with 7,5% growth in the S&P 500 and an 8,8% rise in the average equity mutual fund.


      But how are hedge funds faring now?


      Van predicts hedge funds will "at least break even" during the last quarter of 1997. "If the average fund loses money, it will be just a little bit," he reckons. "I'm confident they're going to significantly outperform the markets and the mutual funds."


      Hedge funds open a new world of investment for South Africans. But, at this stage, local participation in the broader range of funds is limited by the R200 000 exchange control ceiling for individuals. In addition, gaining entry to US funds is subject to strict Securities & Exchange Commissions (SEC) regulations which stipulate that investors must have assets of $1m or income of $200 000 a year. Funds are also reluctant to accept investments of less than $100 000 because they are only legally allowed 99 investors each.


       Dion Friedland, the former owner of Dion Stores, has created four funds that allow South Africans access to hedge funds at an entry level similar to the minimum investment limits set by local institutions for direct offshore investment products.


      An investor can access Friedland's Magnum Group of Funds - which in turn invest in a range of leading hedge funds - by putting a minimum $10 000 into four Magnum Advisors Funds. These are four smaller funds set up by Friedland to feed into his Magnum Group of Funds.


      The Magnum Group of Funds has built up a good track record. The Wall Street Journal Europe and Asia named the largest(Magnum Fund), the top performing fund worldwide for the year to March 5 1996.


      Another option open to investors sceptical of hedge funds is the range of capital guaranteed products. These are becoming widely available in SA and have the full backing of the Reserve Bank.


      The products set out to protect investors in three ways - by guaranteeing capital returns based on the performance of specific local or international indices, guaranteeing a certain level of gearing and (in the case of international funds) protection against currency depreciation.


      The funds are underwritten by call options or overlaid by put options - contracts between the issuer and an overseas investment bank to buy or sell stock at a future date - and insures the product against a market fall while guaranteeing growth and perfect index correlation.


      The main attraction at times of market turbulence is that the products have no downside risk during bear markets because the initial capital invested is guaranteed. In certain instances, returns built up each year are "reset" - or banked - by the fund. Thus, if the market deteriorates the following year, the previous year's returns remain untouched.


      The returns offered by capital guaranteed investments are based on the performance of a local or international equity index, such as the S&P 500, the FTSE 100 or an index compiled by the issuer. The minimum return the investor will achieve over time is in line with the index's positive growth.


      At this stage there are 14 products based on local indices and four on international indices. Local products are offered by Norwich Life, Old Mutual, Sanlam, Syfrets, TMA/Coronation and Fedsure. On the foreign front products are offered by Fedsure Millenium, Syfrets and TMA/Sage.


      Most of the international products also offer full currency exposure, which means that the returns are bolstered by rand depreciation when converted back to the local currency.


      Morgan West director Tom Breslin points out that the investor pays for the benefits offered by a capital guaranteed product by sacrificing the dividend flow normally offered by conventional unit trust products. But this sacrifice seldom amounts to the level of fees charged by unit trust companies while fees are embedded in capital guaranteed products. He adds that the investments are more flexible than unit trusts.


      Risk is also reduced because underlying contracts are set up for guarantees, currency cover and index led returns with offshore investment banks that have credit rating of not less than AA- (higher than the government's risk rating).


      As exchange controls are lifted, there will be greater access to hedge funds. The next major hurdle will be for local investors to overcome the fear and suspicion associated with derivatives and to begin understanding the opportunities they offer.


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