Market volatility was rife throughout 2022, with threats of a recession spilling over into 2023. The outlook for this year remains uncertain but provides areas of opportunity. A certainty of investing is that markets will fluctuate. Hedge funds capitalise on this volatility more so than traditional funds. The world of hedge funds can be highly complex, and it is essential to understand that not all hedge fund strategies are the same. As such, it is worth understanding some basic concepts relating to these investment vehicles.

In short, a hedge fund is an investment vehicle that can employ several strategies to generate returns. These strategies may include using leverage, credit, arbitrage, and short positions.

A long position is where the fund manager buys a share with the expectation that the share price will increase in value. A short position is more complex and is implemented with the expectation that a share price will fall. The fund manager will borrow the share from a brokerage firm and immediately sell it to another investor at the current trading price. When the share price decreases in value, the fund manager repurchases the share in the market and returns it to the brokerage. The profit from the trade (excluding any borrowing costs) is the difference between the price at which the manager initially sold the share and that at which the manager repurchases the share. There is, however, risk associated with a short position. Should the share price increase after borrowing and selling the share, the manager will be required to repurchase the share at a higher price to return it to the brokerage. In this case, the manager will incur a loss equal to the difference between the current, higher purchase price and the original, lower selling price.

Short positions, therefore, enable hedge funds to generate returns even when markets experience downturns. This differs from a traditional long-only fund which can only generate positive returns when the price of its shareholdings increases.

Hedge funds are not a new concept; they have been around since 1949. They have previously only been accessible to qualified investors through Qualified Investor Hedge Funds (QIF), which are associated with sizeable minimum investment amounts of R1 million, and monthly liquidity, as opposed to daily, liquidity.

There were changes to hedge fund regulations in 2015 when hedge funds were declared Collective Investment Schemes and brought under FSCA oversight. These changes also introduced the Retail Hedge Fund (RIF), which made hedge funds more accessible, including via Linked Investment Service Providers (LISP). RIFs have lower minimum investment amounts and allow investors daily liquidity.

A common misconception about hedge funds is that they are extremely risky. In South Africa, there are over a hundred hedge funds with varying degrees of risk.

The following graph illustrates the value of a hedge fund and its ability to generate returns while equity markets decline. We can see how hedge funds use their ability to short shares to lower their overall exposure against market declines and generate steady gains over the period.

Covid-19 was unpredictable; it was an outlier event. Hedge Fund A protected itself against the large drawdown at the onset of the crisis at the beginning of 2020, while Hedge Fund B experienced a drawdown on a much smaller scale than long-only Equity Fund A.

A more predictable circumstance was the market decline at the start of 2022 caused by inflation and the Russia/Ukraine conflict. Both hedge funds delivered positive returns while the equity fund declined, showcasing a hedge fund’s ability to provide downside protection and less volatility than equity markets.




*Past performance is no guarantee of future results

It is important to note that this is only one example of where (these two) hedge funds have performed well, demonstrating a key aspect of the product. Hedge funds do not guarantee that they will beat the market. There is risk when investing, and there are hedge funds that have underperformed in the market. There are examples of hedge funds that have failed due to excess gearing. Thus, it is paramount to understand the nature of the fund in which one invests and how risky its strategy is.

It is true that, in general, hedge funds are expensive. While not unique to the hedge fund industry, they typically charge a performance fee based on their outperformance of a specified benchmark. To assist you in determining whether hedge funds have a place in your portfolio, an advisor can explain the fee structure while simultaneously discussing the diversification benefits provided by such funds.

There are many hedge funds on offer to investors, with varying risk factors. We are not saying that hedge funds are the silver bullet to the world of investing. Hedge funds are not for everyone, but NFB believes they may have a role to play in a suitably diversified portfolio.

You are welcome to contact your NFB advisor to discuss whether hedge funds have a role to play in your portfolio.