Hedge Funds, Funds of Hedge Funds and Platforms

Let’s look at the difference between hedge funds and “traditional” funds, as well as three different approaches to accessing hedge funds with an outline of advantages, disadvantages and costs.

The revised Regulation 28 has sparked renewed interest in hedge funds as an investment destination. Let’s explore the difference between hedge funds and “traditional” funds, as well as three different approaches to accessing hedge funds with an outline of advantages, disadvantages and costs. It’s a complex decision but hopefully our insights will empower you to at least consider hedge funds as part of a diversified investment strategy.

Regulation 28

Regulation 28 previously only allowed 2.5% to the “Other” category which included hedge funds, private equity and other alternative investments that did not fit into the other well-defined “traditional” asset class categories. In 2011 the regulations were updated to provide more detailed guidelines for the “Other” category. The revised Regulation 28 now explicitly allows a 10% allocation to hedge funds with a limit of 5% to a single fund of hedge funds and a limit of 2.5% to a single hedge fund.

What is a Hedge Fund

A hedge fund is a pooled investment vehicle, often structured as a limited partnership that aims to achieve positive returns regardless of whether the market is rising or falling. This strategy is also referred to as an absolute return type strategy. Hedge funds invest in a range of markets and make use of a variety of investment strategies and securities. One can argue that their tool set is just so much wider than traditional managers. Hedge funds may not be marketed to the general public and are mostly accessible to sophisticated or institutional investors such as pension funds.

Hedge Funds vs Traditional (“Long Only”) Funds

 Hedge FundsTraditional “Long Only” Funds
ObjectiveTypically Absolute return i.e. aims to
produce a positive return
Mostly Relative return i.e. aims to
outperform a market benchmark
StrategiesWide freedom, including leverage and
short selling
Limitations, no leverage or short selling
Cultural StyleLean and mean – limited capacityLarge firms - asset gatherers
LiquidityLimitations on redemptions but mostly
monthly liquidity
Monthly liquidity or better – most
funds can provide weekly liquidity
MarketingLimitations on marketing and sellingBroad access to investors
Business
Relationship
Manager co-invests material allocations
with the investor
Manager may or may not co-invest
with the investor
FeesPerformance based fees is typically a
material component
Mostly asset-based management
fee but could also incorporate a
performance based fee

Hedge Fund Strategies

There are many hedge fund strategies available to investors.

Equity Hedge

Equity Hedge managers take a long position (buy) in stocks that are expected to increase in value and a short position (sell) in stocks that are expected to decrease in value.

  • Equity Market Neutral: Equity Hedge strategies that hold equal Rand values of long and short equity positions are called Equity Market Neutral strategies. Portfolios are typically structured to be market, industry, sector, and Rand neutral.
  • Long/Short Equity: Equity Hedge strategies that hold unequal Rand values of long and short equity positions are called Long/Short Equity strategies. Most Long/Short Equity strategies in fact maintain a long bias i.e. their general positioning still remains positive to benefit from a positive performing or upward sloping equity market. The largest portion of the South African hedge fund market is made up of Long/Short Equity funds i.e. approximately 50%.
Relative Value Arbitrage

These strategies exploit market valuation discrepancies through long and short positions.

  • Convertible Arbitrage: Convertible arbitrage strategies attempt to exploit anomalies in the prices of corporate convertible bonds. An example of this strategy is to buy the convertible bond and hedge the equity component by shorting the underlying share. In addition to collecting the coupon on the underlying convertible bond, this strategy also bets on the price of the underlying share.
  • Fixed Income Arbitrage: This strategy attempts to exploit market valuation discrepancies through long and short positions in fixed income securities. This strategy considers the changes in the term structure of interest rates and the credit quality of the fixed income securities.
Event Driven

This strategy focuses on opportunities created by corporate events such as mergers, acquisitions and companies near bankruptcy.

  • Distressed Securities: Distressed securities refer to the debt or equity in companies that are in or near bankruptcy. This strategy believes you can buy a distressed security for less than you can sell the parts for. This however takes patience and due to the relative illiquidity of distressed securities, short sales will be difficult and these strategies tend to be net long.
  • Merger Arbitrage: During a merger the “acquiring company” is trying to buy the “target company”. Merger Arbitrage seeks to capture the price spread between the securities of the two parties to a merger. Typically this would involve buying the securities of the target company and selling the securities on the acquiring company.
Global Macro

Global Macro managers base their view on which securities to buy and sell on macro-economic principles that include global economic and political views. They focus on overall market trends rather than the valuation of individual securities.

Risk Management

When considering investing in hedge funds, operational risks are material risks to understand and to monitor and manage. More than 50% of hedge fund failures are due to operational risks whereas investment risk only contributes to approximately a third of hedge fund failures.

Operational risks are risks which arise from the execution of the business functions of any entity. This is the most complex risk investors face when they allocate capital to hedge funds. Operational risks include:

  • Weaknesses in the manager’s business and operational infrastructure;
  • Deficiencies in accounting controls and procedures;
  • Errors in the Net Asset Value (NAV) calculation;
  • Client reporting procedures

Operational risks include:

  • Weaknesses in the manager’s business and operational infrastructure;
  • Deficiencies in accounting controls and procedures;
  • Errors in the Net Asset Value (NAV) calculation;
  • Client reporting procedures

Compliance risk arises in situations where the laws or rules governing the industry may be untested or violated, along with the procedures and ethical standards. This risk exposes the institution to fines by regulators, civil money penalties, payment of damages and voiding of contracts.

Operational and Investment risk management must therefore be conducted independently from portfolio management. This requires increased efforts regarding due diligence and ongoing monitoring on the part of investors. Specific attention should be given to the following aspects:

  • Share & Sector Concentration Risk;
  • Drawdown Risk;
  • Leverage;
  • Naked Shorts;
  • Gates / Lockups;
  • Liquidity Risk.

Most investors typically utilise a fund of hedge funds manager to manage these risks on their behalf. A new approach that is gaining fast traction is to utilise a hedge fund platform which manages and monitors these risks but the manager selection and investment risk is left to the investor.

Which Hedge Fund Strategy to Select?

We believe that investors should as a first step only consider long/short equity as a hedge fund strategy. This is not only the largest single strategy in terms of assets managed in South Africa but the universe of hedge fund managers have long track records (typically 5 years and longer), the strategy is less complicated than others, it is liquid (i.e. monthly liquidity) and the surprise factor is relatively low.

Long/short equity is mainly designed to reduce downside risk exposure but to maintain adequate upside participation when the market performs strongly. Downside risk is an estimation of a security’s potential to suffer a decline in value if market conditions change. Investment managers can effectively take advantage of both sides of the market therefore long/short equity strategies can also take advantage of falling markets while traditional long-only equity investment managers can potentially only reduce their equity allocation for cash when they wish to protect their portfolio.

Long/short equity hedge funds can been seen as a more actively managed strategy than any long-only equity mandate and is potentially the most active managed equity strategy available for investors who wish to invest across the entire spectrum of equity orientated investment mandates.

Approaches to Investing in Hedge Funds

The key question is then which approach should be followed to implement a long/ short equity strategy i.e. should the investor select a basket of single managers and invest directly into their funds, or rather appoint a fund of hedge funds manager to select the single managers on behalf of the investor? Another option is for the investor to utilise a hedge fund platform which manages the operational risk of a pre-selected universe of single hedge funds from which the investor can select and invest into via the platform. The operational risk is therefore managed by the platform but the manager selection risk remains with the investor as advised by their investment advisor.

 Single Hedge FundsFund of Hedge FundsPlatforms
Investment DecisionInvestor selects one or
more single funds
A multi-manager or fund
of hedge funds selects
the underlying single
funds and packages the
selection into a product
Investor selects single
hedge funds from a
menu of approved single
hedge funds as provided
and approved by a hedge
fund platform
FeesOne layer of fees i.e. the
single manager fees
Two layers of fees i.e. the
fund of hedge funds fees
plus the underlying single
hedge fund manager fees
Two layers of fees i.e.
the platform fees and
the single hedge fund
manager fees

Single Hedge Funds

An investor could select one or more single hedge fund managers and combine them into a diversified portfolio of managers. This strategy is most suitable to sophisticated and educated investors as they will have to be comfortable to assess the investment and operational risks of each single hedge fund manager and will also need to have portfolio construction skills to construct the multi manager solution and performance and risk monitoring skills to continuously monitor and evaluate the total portfolio. Investment advisors could assist investors to implement this strategy. The additional fee which an investment advisor charges for these services are typically 0.10% to 0.20% of the asset size of the investment or as per a time charge basis.

Fund of Hedge Funds

A fund of hedge funds is an investment vehicle that invests in a number of underlying single hedge funds. A fund of hedge funds is managed by an investment manager such as a multi-manager who selects the single hedge funds on behalf of the investor. A fund of hedge funds offer investors with better diversification than investing in a single hedge fund but charges an additional layering of fees for their offering. Such additional fund of hedge funds fees are on average 1% plus a 20% performance fee. Most investors utilise a fund of hedge funds approach as a first
step to allocate to hedge funds. As investors become more educated they may start considering selecting single hedge fund managers with the assistance of their investment advisor.

In recent years offshore funds of hedge funds have shown a continued decline in assets as investors move their capital to single hedge funds. The capital outflows are largely driven by the growing influence of investment consultants on institutional investors, strong growth by single hedge funds and the cost or fee structure on funds of hedge funds amongst other things. This comes as a serious challenge for local funds of hedge funds as investors are now starting to consider hedge fund platforms to reduce the total cost of their hedge fund programme.

Hedge Fund Platforms

Hedge fund platforms offer investors a menu of single hedge funds to choose from and to then construct their own tailor-made combination. The platform acts as a portal or gateway to all the funds approved on the platform. The platform then manages the operational risk and provides a consolidated view of all underlying investment and further acts as one point of contact for the investor. Some platforms even provide assistance with regard to the selection and blending of single hedge fund managers. A platform essentially allows the investor to fulfil the role of a fund of hedge funds manager but with the ability to make his own decisions rather than be dependent on the fund of hedge funds for manager selection. A platform also offers additional tools and services to assist the investor such as research, Regulation 28 reporting and portfolio optimisation.

A platform typically charges 0.30% to 0.50% for their services. In addition, the investor will need to consider the services of an investment advisor to assist the investor with the various decisions and ongoing monitoring of the investment. Overall the platform approach is more cost effective than the fund of hedge funds approach.

Services to Consider

Whether an investor selects single hedge fund managers themselves, or uses a fund of hedge funds or opts to invest via a hedge fund platform, the investor needs to make sure that the following aspects are covered by the service provider/s –

  • Operational and investment due diligence;
  • Manager selection advice;
  • Portfolio construction advice;
  • Fee negotiations;
  • Setting up of legal contract and mandates;
  • Independent performance and risk monitoring;
  • Mandate and legal compliance monitoring.

The table below provides some insight into how a diversified long/short equity portfolio could look like once finally constructed:

 Manager XManager YManager Z
Allocation to
Hedge Fund
40%35%25%
Redemption
Frequency
MonthlyMonthlyMonthly
Notice Period30 days30 days30 days
Full Daily
Transparency
YesYesYes
Valuation
Frequency
DailyDailyDaily
Management Fee0.80%0.50%1.00%
Performance Fee15.00%20.00%15.00%

The objective of the total portfolio could be to provide 60% of the equity market’s upside performance whilst only participating in 30% of the downside of the equity markets when it loses value.

Summary

We recommend that investors that wish to consider allocating to hedge funds for the first time either opt for the fund of hedge funds or the hedge fund platform approach. At least then, operational risk and compliance risk is managed on behalf of the investor as 50% of hedge fund failures occur due to these risks.

Fund of hedge funds and hedge fund platforms manage operational and compliance risk through following rigorous due diligence processes and detailed daily monitoring of the underlying single hedge funds.

Every investor needs to evaluate the cost versus value-add which a fund of hedge funds or a hedge fund platform offers. Fund of hedge funds are more expensive than hedge fund platforms but they offer a one-stop-shop. For the more sophisticated investor a platform approach may be more optimal as the investor can tailor-make their portfolio and at half the cost.

GraySwan produces a monthly performance and risk report covering the hedge fund and fund of hedge fund industry. The results from our proprietary analyses show that the average long/short equity fund of hedge funds underperforms the average single long/short equity hedge fund manager. Therefore, if you as an investor wish to follow a fund of hedge funds approach, your selection of the fund of hedge funds manager remains critical. If you don’t select the most optimal fund of hedge funds manager you could have rather simply appointed a few average single hedge fund managers and you would have produced a similar performance but at materially lower cost.

Investing in hedge funds or fund of hedge funds or via a hedge fund platform is a complex decision. Every investor is unique and the final decision should be guided by many factors such as the level of sophistication of the investor, the time which the investor will spend on the investment, the risk budget of the investor as well as the relative cost of the final investment structure.

Fund of hedge funds and hedge fund platforms manage operational and compliance risk through following rigorous due diligence processes and detailed daily monitoring of the underlying single hedge funds.