Smart Investor  December 1999

by Colin Anthony

"A hedge fund is a fund that can take both long and shorn positions, use arbitrage, buy undervalued securities, trade options or bonds, and invest in just about any opportunity in any market where it foresees impressive gains at reduced risk .... Investment returns, volatility, and risk vary enormously among the different hedge, fund strategies.

-Dion Friedland, Chairman, Magnum Global Funds

I do not give such a lofty description to hedge funds lightly. Yet the advantages hedge funds have over traditional investment vehicles are extensive and impressive. Many of these advantages are derived from their flexibility to profit from a falling market as well as a rising one, and from the wide range of instruments in which they can invest. Of course, I call them the Rolls-Royce of investment vehicles also because only very rich people can afford the minimum investment.

      IF YOU had a choice of driving a car with or without brakes, I think it would be safe to assume that you would prefer being able to stop. Unit trusts have been likened to driving without brakes - if things go wrong they are general able to avoid a crash. This is because they have to stay invest­ed according to their mandates.

      So a general equity unit trust must be at least 75% invested in equi­ties at all times, even when the market is falling. In many cases, the unit trust manager cannot even refrain from new invest­ments because the money keeps coming in from clients, and has to be invested. Note the torrid returns over August-­November last year during the market crisis.

      In bear markets, then, a unit trust may very well beat its benchmark but still lose money. In other words, relatively its performance may be better than its peers, or it has lost less money than other unit trusts in its category. That is why performances are measured on a relative basis.

The two main advantages of investing directly in the stock market yourself are:

• You can sell when the market turns sour; unit trust fund managers cannot; and
• There are no management or administration fees, just broking charges

      Of course not everybody wants to go it alone on the stock market, or some people will play the stock market but will not want to invest all their capital themselves. In fact, unless you are a very experienced investor and know how to analyse companies quite comprehensively, you should invest only a small percentage of your total investment yourself. Don't play around with your retirement provisions.

      There are wrap funds that will alter the asset allocation according to market conditions, moving more of your investment into bonds or cash when equities dive. In many cases though, the mandate of the wrap fund will still determine that a portion of the investment remain in equities.

Freedom

      Few investment vehicles give as much freedom of movement to the fund manager as hedge funds. The hedge fund manager not only has the brakes to avoid a crash by selling all shares in the fund, he has the means to actually take advantage of a downturn by sell­ing short. He can thus make money when shares prices are plummeting.

      Selling short occurs when you borrow shares and sell them, believing that the price will go down. You then buy the shares at the lower price and return them to the institution from which you borrowed them.

      Of course if the share price goes up, the losses can be substantial.

      Hedge funds have further freedom in that they can invest in just about any area where the manager believes there is money to be made. While unit trusts are restricted to equities, bonds or cash, hedge fund managers are free to take a punt on the Japanese yen, buy maize futures or short gold. They scour the markets for arbitrage opportunities - a disparity in prices between two instruments that has to close. For example in a merger or buyout, the shares of the company being bought have to match the buyout price.

Risky

      Hold on a minute, I hear you say, these hedge funds are extremely risky instruments. Look at Long-Term Capital Managers, for example, the US hedge fund run by Nobel prize-winners that went belly-up and was baled out by a number of high-powered institutions.

      True, some hedge funds are high risk, extremely high risk. But these funds pretend to be nothing else and will in fact market themselves on their aggressive invest­ments. Other hedge funds, in fact probably the majority, are far more conservative and are structured to suit the needs of investors. As such some hedge funds will be extremely low risk, others will have moderate risk and so on, just like unit trusts.

      "Only 5% of hedge funds are high risk," says Carla Fiford, chief executive officer of Magnum Global Funds.

      The ones carrying the highest risk are macro funds which "take bets" on the direc­tion of currencies, equities, bonds, etc. "For example, if interest rates in Germany fall, this may weaken the Deutschmark slightly. The fund manager will ask, `What will happen to the dollar and the Euro as a result? And then what will happen to the yen? He might then take a position on the yen falling. This scenario can be played out with any currency, and is usually triggered by a move on interest rates. The fund can make or lose billions in a day."

      But it is a popular misconception that all hedge funds are high-risk investments. Each hedge fund has its own risk classifica­tion according to its investment strategy, and the bulk of these are low to moderate risk.

      There are 14 main hedge fund strate­gies, many non-market correlated, and most are not considered a high risk.

      Mercury Alpha Capital and Magnum Global Funds outline these strategies:

Global Macro

      The manager attempts to benefit from his understanding of global macro economic events. These funds are usually highly leveraged in order to optimally benefit from the events the manager takes positions on, and are consequently the more risky of the hedge funds. They aim to profit from changes in global economies, typically brought about by shifts in government pol­icy which affect interest rates, in turn affect­ing currency, stock and bond markets.

      They participate in all major markets -equities, bonds, currencies and commodities and use leverage and derivatives to accentuate the impact of market moves. These funds also attract much publicity for their higher volatility, for example, the George Soros fund which benefited from the devaluation of the British pound in October 1992.

      However, high potential losses can also occur with these finds, for example, the US-based Long Term Capital Managers that collapsed in late 1998.

Expected volatility: very high

Distresses Securities

      The manager benefits from companies which are being restructured or which are in liquidation. By placing a value on the assets of the company involved, the manager may arrive at a price that is different from the current market price, thus offering a potential trading opportunity.

      The manager can buy the equity, debt or trade claims at deep discounts, and the fund profits from the market's lack of understanding of their true value and because the majority of institutional investors cannot own below investment grade securities.

      This selling pressure creates the deep discount. Results are generally not dependent on the direction of the markets.

Expected volatility: low - moderate

Risk Arbitrage

      The manager benefits from what he believes to be under­valued assets relative to overvalued assets. This strategy requires the manager to compare the valuations of two or more similar assets, value being captured by selling the more expensive asset and buying the cheaper asset.

      The manager may also use futures to hedge out interest rate risk. He focuses on obtaining returns with low or no correla­tion to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage-backed secu­rities, capital structure arbitrage, and closed-end fund arbitrage. Strategies have varying risk levels from low risk derivative/physical arbitrage to higher risk corporate event arbitrage.

Expected volatility: variable

Market Neutral Strategies

      These are similar to risk arbitrage. However, the manager arbitrages in an environment where systematic or market risk is removed or hedged from potential returns. The manager invests equally in long and short equity portfolios generally in the same sectors of the market. Returns are therefore produced only out of stock selection ability. As a result, the strategies are not dependent on the general direction of market movements. Owing to this lack of correlation with benchmark indices, these low ­risk funds can offer excellent opportunities for diversifying traditional portfolios.

      Leverage may be used to enhance returns, and market index fixtures are some­times used to hedge out systematic (market) risk.

Expected volatility: low

Short Only Fund

      These funds attempt to profit through the sale of overvalued counters. They sell short in anticipation of being able to rebuy them at a future date at a lower price. This can be a particularly unattractive mandate in a bull market as the fund performs in the opposite direction to the market (ie the fund is generally negatively correlated to the particular market represented in the portfolio).

      These funds are often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle.

Expected volatility: very high

Fund of Funds

      Analysts optimally combine different hedge funds and other pooled investment vehicles to produce portfolios which are high yielding with very low risk. This is a particularly attractive strategy as diversifying absolute return vehicles generally yields substantial risk reduction benefits.

      This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual fluids. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed.

Expected volatility: low - moderate

Aggressive Growth

      These funds invest in equities where growth of earnings per share is expected to acceler­ate. They generally look for high price earnings ratios with low or no dividends. These are often smaller and micro cap stocks expected to experience rapid growth. Sector specialist funds such as technology, banking, or biotechnology are included.

      The manager hedges by shorting equities where earnings disappointment is expected or by shorting stock indices, but the fund tends to be "long-biased".

Expected volatility: high

Emerging Markets

      The manager invests in equity or debt of emerging markets which tend to have higher inflation and volatile growth.

Expected volatility: very high

Income

      These funds invest with a primary focus on yield or current income rather than solely on capital gains. They may use leverage to buy bonds and sometimes fixed income deriva­tives in order to profit from principal appreci­ation and interest income.

Expected volatility: low

Market Timing

      Assets are allocated among the different asset classes depending on the manager's view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. The unpredictability of market move­ments and the difficulty of timing entry and exit from markets adds to the volatility of this strategy.

Expected volatility: high

Opportunistic

      The investment theme changes from strategy to strategy as opportunities arise to profit from events such as companies about to list on the stock exchange, sudden price changes often caused by an interim earnings disap­pointment, hostile bids and other event-driven opportunities. The manager may utilise several of these investing styles at a given time and is not restricted to any particular investment approach or asset class.

Expected volatility: variable

Multi Strategy

      The investment approach is diversified by employing various strategies simultaneously to realise short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to use different strategies to various extents to best capitalise on current investment opportunities.

Expected volatility: variable

Special Situations

      The fund invests in event-driven situations such as mergers, hostile takeovers, reorganisations, or leveraged buyouts.

      It may involve the simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. It may also use derivatives to leverage returns and to hedge out interest rate and/or market risk.

      The results are generally not dependent on the direction of the market.

Expected volatility: moderate

Value

      The manager invests in securities he perceives to be at deep discounts to their intrinsic or potential worth. Such securities may be out of favour or neglected by analysts. Long-term holding, patience and strong discipline are often required until the ultimate value is recognised by the market.

Expected volatility: low - moderate

Choices

      Fiford says this wide range of choices and freedom of movement tends to result in the best fund managers gravitating to hedge funds. It can also be more lucrative. She says unit trust managers usually get paid a salary plus a fee for assets under management. The hedge fund manager typically works for himself and does not get a salary. He will receive a percentage -1% to 1,5% - of assets under management and pay his operating costs from that. The real money comes in from the incentive-based structure whereby the fund manager receives 15% to 20% of whatever he beats his benchmark by. This can be a handsome sum.

      Hedge fund managers are also usually heavi­ly invested in a significant portion of the funds they run and share the rewards as well as risks with the investors. Magnum chairman Dion Friedland says "incentive fees" remunerate hedge fund managers only when returns are positive, whereas mutual funds or unit trusts pay their financial managers according to the volume of assets managed, regardless of performance. "This incentive fee structure tends to attract many of Wall Street's best practitioners and other financial experts to the hedge fund industry."

Private Investor

      There are two main reasons why private investors have little exposure to hedge funds: the minimum investments are extremely high and hedge funds are not allowed to solicit for business. "A financial adviser worth his salt will offer suitable clients the hedge fund option," says Fiford, "but we are not allowed to solicit."

      Typical clients of Magnum Global Funds and most hedge fund managers are institutions and high net worth individuals. For both, Magnum will customise the investment to suit the client.

      Magnum's minimum investment in local rand funds is R100 000 and $10 000 for an offshore fund.

      Fiford says that the only way for South Africans to invest in a hedge fund where the minimum investment is more than the foreign exchange allowance of R500 000 is to pool two allowances, for example those of a husband and wife, into one investment.

Returns

      After all is said and done the relevance of hedge funds as an investment, like any other investment, are the potential returns. Friedland says their returns over a sustained period of time have out­performed standard equity and bond indices with less volatility and less risk of loss than equities. "Beyond the averages, there are some truly outstanding performers."

      Citadel's Terence Moll and Francois Muller say a US study found that hedge funds yielded just over 14% per year, on average, between 1993 and 1998 -slightly higher than world equity funds (13%), with one-third less risk.

      Again it must be emphasised, though, that strategies and risk profiles vary widely.

      "A wide range of established conservative funds employs various strategies to produce consistent US dollar returns of between 10% and 15% (as high as normal equity returns in the long term), but with less volatility than bonds," say Moll and Moller.

      They point out that in the three worst quarters in the US equity market over the past 10 years (Q3 1998, Q3 1990 and Q 1 1994), hedge funds also suffered but lost only one-third to a half as much as equity funds.

      Friedland says investing in hedge funds tends to be favoured by more sophisticated investors, including many Swiss and other private banks, who have lived through and under­stand the conse­quences of major stock market corrections. "Many endowments and pension funds allocate assets to hedge funds."

      Their success has resulted in growing popularity. They were only introduced in South Africa very recently and in the last eight years, the number of hedge funds worldwide has risen by about 20% a year and the rate of growth in hedge fund assets has been even more rapid. "There are estimated to be 4 000-5000 hedge funds managing $200bn-$300bn," says Friedland. In SA the figure is estimated to be R2bn against R100bn in unit trusts.

      "While the number and size of hedge funds are small relative to mutual funds (unit trusts), their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors," says Friedland.

      Moll and Moller say hedge funds are to form an important part of Citadels financial solutions in fixture. But they warn potential investors of some pitfalls. "The single most important dan­ger is that the industry is still unregulated in most countries. This calls for extremely thor­ough research before an investment is made."

      They say that recent studies in the US recommended that all pension funds should have some money in hedge funds. "Though still small compared with traditional funds, the hedge fund industry is growing rapidly. Investing a portion of ones assets (15% is nor­mally recommended) in hedge funds will help ensure a smoother ride and decent returns, even if traditional assets are subdued."