The only way to protect against market uncertainty is by having a diversified portfolio. Diversification away from equity markets provides risk buffers in the form of uncorrelated investments which can outperform when equity markets do not. Traditionally, investors would hold assets such as cash, government bonds, preference shares, gold, or even rare art, with the aim of gaining a return profile that is different to that of the general equity market. However, hedge funds are becoming a preferred diversification tool.
WHAT IS A HEDGE FUND?
In a traditional sense, hedge funds fall into the alternative investment category. Their aim is to hedge out market risk in order to provide investors with the best risk-adjusted returns. However, hedge funds have often been used as a vehicle through which fund managers invest in strategies that they could not incorporate in a traditional unit trust.
There are various strategies within the hedge fund universe, and in South Africa we can break them down as follows:
- Long/short – A strategy where the fund can purchase stocks that are undervalued and sell short stocks that are overvalued.
- Market neutral – The overall aim of this strategy is to have little or no exposure to the market. Managers might effectively cancel out equity market exposure by adopting a long/short approach, or by holding instruments that have little to negative correlation with the equity market.
- Fixed income – Managers can use the basic concepts of long/short and market neutral, but they do so by only using fixed income instruments (credit, bonds and cash).
- Multi-strategy – This is a wider category where managers have the flexibility to use a combination of approaches.
- Fund of funds – This is a fund structure that holds other funds that have a variety of strategies or a single approach. The aim is to provide investors with a desired risk and return profile.
- Other – There are various other niche strategies which could include commodities, merger arbitrage, event driven and relative value. However, in South Africa most hedge funds belong to the five groups noted above.
WHAT EXPOSURE DOES A HEDGE FUND OFFER?
When it comes to hedge funds, exposure can be divided into gross and net exposure – where gross exposure is an absolute measure and net exposure is a relative measure. Given the strategies that hedge fund managers can employ, it is possible to have a 200% gross exposure but 0% net exposure (100% long and 100% short). This is also a classic example of the use of leverage without taking on any market exposure.
Conversely, an exchange traded fund (ETF) that tracks the FTSE/JSE Top 40 Index should, in theory, provide 100% net exposure to the top 40 stocks listed on the JSE All Share Index. This ETF should perform in line with the FTSE/JSE Top 40 Index; whereas a hedge fund with 50% net exposure would most likely provide half the upside and half the downside of this index.
A hedge fund should be able to outperform an equity market if it has more than 100% net exposure to that market, however, when equity markets turn negative such a fund could fall more than the market. Market neutral funds are the most common option for investors seeking little to no equity market exposure. Good market neutral funds are able to provide positive performance in periods where equity markets are negative.
HEDGE FUNDS AND CORRELATION
Correlation is a measure of the degree to which two variables move in relation to each other. Correlation values fall between 1 and -1; where 1 is a perfect correlation, 0 is no correlation and -1 is a perfect negative correlation. One can measure the correlation of a hedge fund against the various equity market indices in order to understand how that fund might perform in relation to the relevant index. Hedge funds with very low to negative correlations to equity markets are desirable to investors who are looking for downside protection in periods where equities are negative.
Hedge funds are not all the same, since their make-up can differ significantly. There are also boutique hedge funds which are so niche that they are designed to be part of a broader diversified portfolio, rather than serving as a standalone investment.
From the explanations above one could deduce that it is possible to find a hedge fund that could display one or more of the following traits: negative exposure, negative correlation and/or higher risk-adjusted returns when compared to equity markets.
We think hedge funds have the ability to deliver on specific risk and return objectives and, where appropriate, should be considered in constructing a well-diversified portfolio. The primary objective of our hedge funds is not to outperform equity markets, but rather to act as risk buffers.
Written by Kumendra Naidoo, Citadel Junior Investment Analyst