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Sunday August 07 2022
But They're Swans


The ugly ducklings are now the funds of choice of many wealthy individuals and pension funds


        The pain in the international hedge fund industry has been intense last year the giant LTCM (Long Term Capital Management) was saved from burning out completely only by the intervention of the US Federal Reserve, which persuaded banks to throw it a US$3,6bn lifeline. Now it's the turn of the world's largest hedge fund, Tiger Management, whose funds under management have been squeezed to $8bn from a $20bn high last year. Its fund manager, Julian Robertson, is shouting down European investors for jumping ship while investment decisions were being reversed and the fund's high leverage reduced. But who would condemn them?


        Hedge funds are blamed for currency crises and the recent fall in the gold price. They take the rap for undervalued shares of blue chip companies and overvalued Internet stocks.


        The reality behind this epic action adventure in which hedge funds are frequently going up in flames is an equally gripping story about an industry well on its way to becoming the preferred fund management style for wealthy individuals and a must for every pension fund.


        There are scores of hedge fund managers who are more conservative than action heroes (or villains) like Tiger Management's Robertson or Quantum's George Soros. They work hard to protect their investors from the market's ups and downs by offering them absolute, rather than relative, returns. They aim to produce positive gains rather than trying to outperform benchmarks such as market indices.


        There are only a handful of hedge funds that have assets running into billions of dollars and take big, risky bets on macroeconomic market moves. The rest of the industry - the much larger part of it - is characterised by far smaller funds (often less than $100m) run by ultraconservative investors who promise market-neutral returns to their investors.


        It is these funds that are attracting pen-sion savings and the investments of the wealthy. Just for example, the £23bn Coal Pensions Fund, the biggest in the UK, recently reported it would substantially increase its investment in hedge funds as a way of insuring against stock market losses.


        Van Hedge Funds, a Nashville-based hedge fund adviser, calculates that US and offshore (based outside the US, invested in the US) hedge funds have been the best performers this year. The US funds they track delivered 16% and offshore hedge funds 15,7%, compared with the Equity Mutual Fund index's 9% return year-to-date and the S&P 500 index's 8,3%.


        It also reports 330 hedge funds were set up during 1998, expanding the universe to 5 830 funds responsible for $311 bn.


        Hedge funds have recently had their wings clipped. There has been a noticeable increase in bank scrutiny and tightening up of credit lines since the LTCM debacle.


        Other measures to regulate the industry are being discussed. The US government released a draft Bill late last month that, if passed, would require hedge funds to give the regulators, banks and public quarterly reports on performance, gearing and risk without disclosing proprietary trading information. But there's a high degree of scepticism about whether the legislation will ever be passed, because it would probably force hedge funds to move offshore and become even less transparent.


        A recent Arthur Andersen survey confirms the still rapid growth in hedge funds, especially in Europe. Bradley Ziff, principal of the consultancy's global derivatives and risk management group, says: "We believe there has been a manifold increase in hedge funds in Europe over the past year or two and that there are now more than 100 funds active in the region." He notes that the European funds don't have the same risk appetite as the US funds.


        The consultancy firm also found spots in Asia where growth in the hedge-fund industry is likely to occur, such as Singapore, Tokyo and Hong Kong.


        Ziff says SA is likely to experience exponential growth off a small base in its hedge-fund industry during the year ahead. The hedge-fund industry is still tiny - an estimated R2bn including investment-bank proprietary trading books - and dominated by a few players. There are three listed local hedge funds, countless in-house funds that are establishing a track record before going public, and several offshore SA hedge funds (set up offshore by South Africans and investing in SA equities).


        Two of the listed funds have joined forces with Arthur Andersen and Werksman's to set up a Hedge Fund Association (HFA) to establish standards of practice.


        At this stage, there is some scepticism about the association's independence. The Financial Services Board turned down an invitation to join and thus the HFA board is dominated by two hedge funds, Mercury Consolidated Holdings and Magnum. Magnum CEO Carla Fiford and Mercury CEO Kevin Shames are the founding presidents.


        Local hedge funds have been in place only during the latter half of the Nineties. BOE was one of the earlier participants and has built up a reliable track record over the years. Kevin Cousins is in charge of BOE's offshore $7m SA Omni Fund. He cut his teeth on alternative fund management strategies when he started running the smaller, in-house Mercury hedge fund three -and-a-half years ago.


        Cousins has a conservative attitude to risk and will invest only if his quantitative mind is satisfied there is little or no chance of losing money. Investors can take comfort from the fact that Cousins's incentive fee is reinvested into the hedge fund, which means that, over time, a larger and larger slice of his personal wealth is tied into the fortunes of the fund.


        SA Omni Fund has delivered a return of 32% since September last year. At that time, the fund had just been fully con verted from a growth fund into a long/short hedge fund. This allows the fund manager to take either a long position, buying stocks, or short exposure, sell-ing borrowed scrip because the share is expected to decline.


        It has been almost a year since James Gubb and Frederick Bouchard left Southern Life to run three African Harvest hedge funds; they are in their element. Their enthusiasm shows in the unaudited results delivered by the three funds under their management: the conservative fund returned 30% (gross) for the year to end September and the balanced and aggressive funds delivered 100%. Gubb says about 20% needs to be taken off for fees.


        The two-man team is also highly conscious of risk: though allowed to gear the capital three times, they have never been that high, nor have they ever had a net exposure to the market of more than 10%.


        African Harvest is probably going to launch an offshore hedge fund in association with Magnum, the listed fund-of funds group, within the next six months.


        Not all fund managers have made the transition to hedge fund management as easily Steve Mills, who runs one of the three listed hedge funds, is in a tight spot. His fund, Mercury Alpha Capital (MAC), is dangerously overexposed to the market because of a hedge mismatch. The fund has begun to pay the price and, last week, MAC had to notify investors that it had underperformed its benchmark during September.


        There's a world of difference between conventional and alternative (hedge) fund management. Mainstream asset managers are long-only investors and deliver positive returns when the market rises. Their investment choices are limited to asset allocation and stockpicking.


        Hedge fund managers have a much wider array of investment styles to choose from because they can go long and short of the market. That allows the managers to get involved in event-driven arbitrage and relative value - two of the most common strategies used by the local fund managers.


        Event-driven arbitrage occurs when a fund manager spots an opportunity that is likely to arise when companies are about to do a deal or announce a change. The fund manager buys the stock in anticipation of the event after carefully working out how much he is likely to make in a defined time period. The only risk is that the transaction may not go ahead.


        Relative value exploits inefficiencies in pricing between different shares, such as a holding company and its subsidiary.


        As more and more asset managers and investment banks get in on the action, the opportunities to make a lot of money on market inefficiencies are likely to decline. But the hedge fund managers say there are still exciting opportunities.


        The growth in alternative investment is being constrained by the shortage of scrip lenders, but the pool of available stock is expected to grow substantially as soon as Share Transactions Totally Electronic (Strate) has put all companies on to electronic settlement.


        Another difficulty, as Mills has experienced, are the limited ways a hedge fund can be set up. They can either be listed, such as Corohedge, MAC and Magnum Global Funds, or set up offshore. For many investors, the listing option is not ideal because the shares usually trade at a discount to net asset value.


        BOE plans to list a local hedge fund within the next six months. Cousins will not list a fund and thinks it is possible to set up a better structure within the existing dispensation.


The market here is in its infancy and there is still a high level of caution about what hedge funds can offer and do. But it is building up capacity and will get to the point where its attractions to investors become blindingly obvious. Sharon Wood The FM's International Hedge Fund Symposium takes place in the first week of November Details on website www.hedgeconference. or Tel: (011) 327-4945.

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