Proving the benefits of hedge funds

As the world strives to return to some form of normal behaviour, after the chaos caused by the COVID-19 pandemic, investors remain anxious. Equity and debt markets faced their worst losses since the Great Financial Crisis of 2008 and the All Share Index lost nearly 22% in the first quarter of 2020. Concerns around a fragile economic recovery and volatile markets are reinforcing the age-old question: how can you protect capital in poor economic markets and then take advantage of capital gains when markets start to rally and growth is restored?

The hunger for asymmetrical investment opportunities is the principal goal of many active investments. The aim it to grow your wealth when markets are flourishing and protect it when markets are struggling. But what are the options?

Traditional long-only investment funds achieve this outcome by trying to outperform the market. This is not an easy task, but can result in relatively better performance than the market. However, it is important to note that when a market experiences negative returns, a successful fund manager could outperform the market but still produce negative returns. The fund will thus have produced alpha in relative terms but in absolute terms it will still have lost previously earned wealth.

A solution to this conundrum is to invest in hedge funds. Hedge funds benefit from a number of additional tools that can be used to improve performance above that of more traditional long-only type funds. These tools better equip hedge funds to produce positive absolute returns, enabling them to perform in line with asymmetric investment goals. Previously considered obscure and risky, hedge-fund performance has garnered attention over recent years. Typically, they aim to produce a performance profile that is characterised by lower volatility, considerable downside protection together with upside capture that should result in overall superior risk-adjusted returns compared to their long-only counterparts.

The rolling 12-month performance chart in Figure 1 (based on median monthly return) illustrates the considerable difference in volatility of single-managed hedge funds as compared to their long-only equity counterparts, as well as the broad equity and bond markets. Aside from the notable improvement of reduced risk, the relative return profile for hedge funds is almost predictably stable, at around 10%. Over time, although tempered, single managed hedge funds have performed quite consistently. The protection provided by this asset class has allowed the cumulative gains of hedge funds to meet the broad equity market, outperform the bond market and substantially outperform the ASISA South African General Equity composite by more than 45% over the period.

Figure 1: Performance of singe managed hedge funds versus various indices.

Figure 2 illustrates the negative performances of key indices in relation to single-managed hedge funds. The time periods needed for recovery can also be observed. South African long-only funds have not been spared from market volatility, often experiencing losses deeper than that of the equity market itself. Comparatively, single-managed hedge funds have fared tremendously well, with minimal drawdowns and recoveries fully made up within three months at most.

Figure 2: The comparative drawdown profiles of indices.

During the Great Financial Crisis of 2008, drawdowns experienced by South African long-only managers reached negative levels of 36%, although on average these managers still outperformed the market. In the first quarter of 2020, the average long-only manager experienced an even steeper drawdown to negative 25% compared to the market that reached negative 21.7%. In comparison, the deepest drawdown experienced by the median South African single- managed hedge fund was negative 7.1%, a large portion of which was made up by the market recovery in April.

The local hedge fund market can be sub-categorised into four broad strategies, being long/short equity, fixed income, market neutral and quantitative, and multi-strategy funds. Each of these fund types employ nuanced strategies in their respective niche areas of the market. The funds use tools like short selling, leverage and derivatives to draw out alpha in every way possible. The sub-categories demonstrate different features in terms of both alpha and volatility expectations.

The complexities underlying hedge funds have been dealt with by the regulator to a substantial extent. Hedge-fund regulation has come a long way to assist investors in understanding and managing the risks associated with the asset class. This, together with reduced fees and a spike in retail market interest associated with hedge funds is a leap in the right direction. It is clear that hedge funds can provide capital protection when markets are struggling and grow wealth for investors during booming markets. Hedge funds demonstrate a consistently reduced risk profile, providing investors with a smooth performance ride. To a large extent, the merits of hedge funds have been proven, but like any type of investment, consistent and superior alpha can only be generated by truly skilful managers.

Download