Understanding the hedge fund industry in South Africa

*This content is brought to you by 36ONE

Whether its due to the dramatization of Hollywood, a general lack of understanding around the various strategies or maybe even due to the GameStop short squeeze – institutional and retail clients in South Africa haven’t embraced alternate asset classes and hedge funds in particular, like the rest of the world. While the American hedge fund industry is over $4.5tril in size, the South African hedge fund industry is only around 0.1% of the size at just over $6bil. On a market cap adjusted basis, the US hedge fund industry is 15x the size of the South African hedge fund industry. This shows the perceived lack of interest in hedge funds in our country historically.

The global hedge fund industry is a lot more complicated to navigate due to the number of different strategies employed by hedge funds. These include macro/event driven, long/short equity, multi-strategy, fixed income, relative value and merger arbitrage strategies – to name a few. The South African industry is a lot simpler with long/short equity accounting for around 60%.

Long/short equity is a simple investing strategy that takes long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short equity strategy seeks to minimize market exposure while profiting from stock gains in the long positions, along with price declines in the short positions. A long/short equity strategy essentially aims to use short positions to limit drawdowns, while participating in equity upside.

This strategy is well suited for the volatile times in which we currently find ourselves in. Let us look at the below example using our 36ONE long/short hedge fund strategies. From inception of the 36ONE Hedge Fund* (April 2006), the average down month in the ALSI ** was -3.2%, while the 36ONE Hedge Fund only declined -0.1%. In the average up months, the ALSI was up 3.6%, while the hedge fund participated in that upside being up 2.2%.

Overall, this has led to compound annual performance of 15.9% net of fees vs the ALSI of 10.5%. This is more than a 5.4% per annum outperformance over a ~16-year period.

The second graph below re-iterates the long term out performance of the 36ONE Hedge Fund vs the ALSI. Assuming an original lump sum investment of R1 000 000 invested in the 36ONE Hedge Fund and the ALSI. A staggering 120% higher portfolio value if you invested in the 36ONE Hedge Fund, with significantly less risk over the period.

Another misconception with hedge funds is that they are considered higher risk/reward than a traditional equity fund. While this could be the case with complex hedge fund strategies, such as a merger arbitrage or a macro fund, traditional long/short equity funds are meant to deliver returns with much lower risk metrics than a traditional equity fund. This is due to the ability to short stocks, which reduces the net equity exposure, so drawdowns should in theory be lower.

If we look at the 10 worst monthly drawdowns of the ALSI, the 36ONE Hedge Fund has materially outperformed in all 10 of those months, given the fact that it is able to manage its net equity exposure over time.

There’s always a fear for investors to not try and time the market, as missing the best days in the market leads to suboptimal returns over time. While this is important, it is far more important to aim to limit drawdowns as much as possible if trying to optimize returns.

An example of this is if we look at the S&P500 return over time. The price return of the S&P500 since 1930 to the end of 2020 was 17.7%. If you had missed the 10 best days and the 10 worst days each decade, your return would have been 27.2%. This simply illustrates that its far more important over time to focus on limiting drawdowns than it is to fear missing out on upside.

Source: Bank of America

Therefore we believe hedge funds, and in particular the 36ONE hedge funds, are attractive funds to include in a clients’ portfolio, as they generate superior risk adjusted returns over time by reducing drawdowns and downside risk, whilst delivering on the upside.

Another fallacy with hedge funds is that they are opaque and complex products that can only be accessed by a select few. The South African hedge fund industry is strictly regulated by the Collective Investment Schemes Control Act. There are extremely thorough processes to register a hedge fund, as well as gross exposure limits to avoid excessive risk taking in funds.

Accessibility is also a lot easier than previously, with hedge funds available on the majority of the major LISP platforms, such as Allan Gray and Glacier.

The 36ONE long/short hedge funds can form a very useful part of an investment portfolio, as they have the potential to provide investors with returns that are similar to an equity mandate, but with much lower drawdowns and levels of volatility. Therefore, resulting in overall better risk-adjusted returns.

We believe our 36ONE SNN Retail Hedge Fund is a fantastic compliment to a well-diversified portfolio in both pre and post retirement and is now available on most major LISP platforms.

Please get in touch with us to learn more.

Disclaimer:
* 36ONE Hedge Fund refers to the 36ONE SNN QI Hedge Fund.

** Alsi refers to the FTSE/JSE All Share TR Index.

The information presented here is not intended to be relied upon for investment advice. Various assumptions were made. See our full disclaimer here.
Source: Bloomberg, 36ONE Research; Data and performance to 30 September 2022.

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