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What do hedge fund managers do?

IN A NUTSHELL: Hedge fund managers use innovative strategies to ensure expected returns are realised in both upward and downward moving markets.

Hedge funds use complex strategies in order to achieve optimal risk-adjusted returns, but how does a day in the life of a hedge fund look? And how is risk managed?

In South Africa, as is the case globally, the hedge fund manager typically consists of a team of licenced specialist investment professionals that – in accordance with the rules and methods of the fund agreement – manages the fund.

How a hedge fund management team operates

After setting up a hedge fund with a specific objective and mandate, the hedge fund managers need to find ways to ensure expected returns are realised. They need to do this while staying within the risk profile agreed upon with investors.

This implies that fund managers are typically required to:

  • Formulate views on the macroeconomic environment and the potential impact on financial markets and asset classes.
  • Perform detailed bottom-up research on listed equities, bonds and financial instruments across the relevant investment markets.
  • Construct and monitor a portfolio that consists of the securities and instruments that represent the fund manager’s best view of how to achieve the portfolio’s investment objective, given the prevailing market conditions.
  • Monitor the risk metrics of the portfolio to ensure that at all times the risk is acceptable and falls within the mandate and regulatory limits.
  • Monitor and reconcile daily and monthly cashflows and trade accordingly.

On a day-to-day basis, hedge fund managers and their teams will thus be involved in:

  1. Accessing and doing research.
  2. Talking to analysts and experts in relevant asset classes (within their teams and externally).
  3. Making decisions on what to buy and sell, and how best to execute such transactions. For example, deciding how much leverage to use, and giving instructions to trade.
  4. Maintaining processes and systems that can provide up-to-date views of their exposure in the markets. This includes giving instructions to rebalance portfolios that carry too much risk.
  5. Working with qualified partners to execute trades, do valuations and administration.
  6. Reporting to and engaging with various stakeholders, including regulators, management companies (Mancos) and investors to meet legal and mandatory requirements.

 Hedge fund risk management

  • The funds are compelled to appoint an independent
  • trustee. The trustee is usually a bank that is not affiliated with the unit trust company or asset manager;
  • Additional risk management and compliance monitoring of hedge funds are performed independently from the asset manager;
  • The Financial Sector Conduct Authority (FSCA) conducts ongoing supervision, ensuring that hedge fund regulation is aligned with the local unit trust industry;
  • Industry integrity is promoted;
  • Investors enjoy enhanced transparency on matters such as fees, and portfolio turnover ratios are disclosed more frequently.

Are all hedge funds high-risk investments?

The fact that hedge funds often take leveraged positions on future markets could result in higher risk. It is, however, not a given that hedge funds are higher-risk investments than long-only funds. For example, hedge funds that combine long and short positions may reduce volatility or exposure to downside risk. In South Africa, the prevalent hedge fund investment strategy is long-short, aimed at reducing risk.

For some South African hedge fund managers the purpose is actually to reduce risk, whether it’s through short selling or diversification into various asset classes. There are, of course, exceptions, where hedge funds manage very concentrated, highly geared portfolios, but these are not the ‘norm.’

While there are still a number of highly aggressive hedge funds in South Africa, these are typically single mandates run for clients that can tolerate that type of risk. Leveraging lucrative positions can actually provide geared exposure, which can be attractive from an investor perspective. This feature is unique to hedge funds, seeing that traditional long only portfolios do not employ leverage.

GLOSSARY

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.

Let’s explain:

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, the Financial Sector Conduct Authority limits leverage for hedge funds that invest on behalf of retirement funds and the man or woman on the street.