Did you glaze over the bits about hedge funds while watching the movies The Big Short and The Wolf of Wall Street? Yes, it’s complicated, but it all comes down to managing risk in innovative ways.
What is a hedge fund?
Hedge funds aim to generate high returns for their investors regardless of market conditions. They do this by using an array of complex investment strategies that allow them to take more risk than a traditional investor would take. In return they can expect a higher return.
Let’s start at the beginning. Traditional funds, like equity or balanced funds, typically generate returns through taking what is called long positions. In short, they buy shares, hold on to them and sell them at an opportune time to generate wealth for their investors.
Hedge funds use the above traditional investment strategy as well as a range of non-traditional ones, including, among others, long and short equity strategies, market-neutral strategies and leverage to generate returns.
Ata wants to know….
Why the name?
An Australian, Alfred Winslow Jones, created the first hedge fund in 1949. At the time Jones’ innovative market-neutral approach was seen as “hedging” risk against the market. Hedge funds only took off in South Africa in the nineties.
Hedge your bets
According to the Cambridge Dictionary hedging means “to protect yourself against loss by supporting more than one possible result or both sides in a competition”.
Here are three strategies hedge funds use to make money for investors:
1. Long and short equity strategies: Before we go any further, it is important that you understand “short positions” or short selling. Short positions are taken where fund managers, based on their research, expect the price of an asset (e.g. share price) to drop in the future. Through this strategy a hedge fund can generate returns even if the market is on a downward trend.
MultiChoice’s share price is R50. A portfolio manager at a hedge fund believes that MultiChoice’s share price will fall in the future. Her fund then borrows 100 MultiChoice shares from a broker and sells them in the market for R5000. Within a few weeks MultiChoice’s share price drops to R30, as she predicted. Her fund then buys 100 shares (costing R3 000) and returns them to the broker. By using this strategy the hedge fund made a profit of R2 000 for its clients in a downward market.
Hedge funds don’t only take short positions. Many hedge funds operate a combination of long positions as well as short positions. This strategy entails taking long positions (buy-hold-sell) in assets that are expected to increase in value and short positions in assets that are expected to decline in value in the same sector. This strategy seeks to minimise market exposure, while profiting from price gains in the long positions and price declines in the short positions. In South Africa, the combination of long and short equity strategies is most common.
In the energy sector, a hedge fund can take a long position on a renewable energy company, while short shelling a coal mining company, based on research that suggests the increasing move towards clean energy will result in the value of the coal mining company’s shares declining over time.
2. Market neutral: In a market-neutral equity strategy, funds take similar-sized long and short positions in the same sectors. The aim is to profit from both increasing and decreasing share prices.
A hedge fund takes a long position on the five online streaming shares that their research shows will outperform and short the five online streaming shares that will underperform. If all goes according to plan, the gains should offset the losses regardless of what happens in the market.
3. Leverage: In this strategy fund managers are convinced of high returns on a specific asset. They then borrow money on top of their available capital to increase the potential return of an investment. This can result in much higher returns than just using one’s own capital, but also significant losses. For this reason, the Financial Sector Conduct Authority as regulator limits the use of leverage in regulated hedge funds in South Africa.
At the beginning of the Covid pandemic Nomnikelo’s hedge fund wants to buy R100 million worth of shares in a hand sanitiser company, but the fund only has R50 million of its own capital available. They then borrow another R50 million and buy the shares. During the pandemic the shares rise to R200 million. In other words, the value doubled. But because Nomnikelo’s hedge fund borrowed R50 million they have R150 million after paying back the R50 million borrowed. So instead of making a profit of just R50 million, they made R100 million profit on their R50 million investment. That’s double the money!
However, if the share price had dropped to R20 million and they had to sell the shares (for which they paid R100 million) at this low price, they would have lost their own capital (R50 million) and would only be able to repay R20 million of the borrowed money. This leaves them R30 million short. This loss is in addition to brokerage and other fees. If the hedge fund does not have other assets that can offset this loss, the fund and investors’ money will be wiped out. For this reason, leverage is limited for hedge funds that invest on behalf of retirement funds and the man or woman on the street.
Can I invest in a hedge fund?
Yes, if you have an extra R50 000 lying around you can invest in a regulated hedge fund for retail investors, called an RIHF. That is the minimum investment amount for a retail hedge fund.
Big Brother is watching.
Hedge funds are often regarded as “dangerous investments” due to them historically being unregulated – particularly globally. In 2015, new regulations in South Africa allowed for hedge funds to fall under the Collective Investments Schemes Control Act (CISCA) and be formally registered as collective investment schemes. The new regulation has allowed for greater transparency, liquidity, and risk control measures than were required in the past.
TO RECAP: Hedge funds manage money with the objective of achieving optimal risk-adjusted returns.
It means they want to give the best returns relative to the risk they are taking. In addition to traditional long investment strategies, hedge funds can use non-traditional investment strategies, including, among others, short selling and leverage. Using more strategies allows them to generate returns in both rising and falling markets.
While hedge funds typically invest in the same asset classes as traditional unit trust funds, they can take advantage of a broader range of investment tools and thereby generate other sources of return.