There exists a popular misconception that hedge funds are volatile creatures that use an array of creative strategies to place large directional bets on stocks, currencies, bonds and commodities while using excessive leverage. In reality, hedge funds are misunderstood and often not understood at all.

The size of the hedge fund industry in South Africa is a mere R40 billion in AuM, compared with that of the unit trust space, over R1.4 trillion. However, due to the recent change in Regulation 28 and the proposed changes to the Collective Investments Schemes Control Act (“CISCA”), the hedge fund industry is perfectly poised for rapid growth. As early as next year, regulated hedge funds may be offered to the man on the street for the first time. If these CISCA regulated hedge funds in South Africa prove to be anything like their European UCITS cousins, it’s going to be a race to get in and IFAs will play an important role in the growth of this industry.

“UCITS funds have proven to be an outstanding European success with more than 35 000 funds representing nearly EUR 6 trillion being distributed to a significant number of countries throughout the world. The success is largely due to the robustness and adequacy of the legal framework that has allowed a dynamic industry to flourish”

Nathalie Dogniez – KPMG Executive Briefing March 2013.

But what is it about hedge funds that have traditionally made them difficult to digest? Perhaps the single biggest reason has been the lack of education resulting from their relative inaccessibility both from an institutional and retail perspective.

Regulation 28 now provides for the fact that pension funds may directly invest up to a maximum of 10% in hedge funds with the caveat that the maximum allocation to a single hedge fund is further limited to 2.5% with a 5% maximum for fund of hedge funds. Previously pension funds could only invest up to a maximum of 2.5% in total into an “other” category which included hedge funds, amongst other alternative asset classes. While this change was welcomed by local managers and is no doubt a major step forward for the industry, the effects of the change have yet to be seen.

On the retail front the imminent change to the CISCA environment is an exciting development for the hedge fund community. Proposed changes to the Income Tax Act and CISCA will open the door to retail investment in hedge funds. The hedge fund industry has to date been relatively unregulated except that local hedge fund managers have been regulated under the Financial Advisory and Intermediary Services Act (“FAIS”) since 2007. We expect this to change if the Minister of Finance agrees to include all hedge funds under the regulation of CISCA.

Current tax and regulatory proposals make way for two distinct hedge fund categories:

“Retail” hedge funds, as the name suggests, will be freely available to members of the general public. For this privilege however, the funds will be subjected to more rigorous regulation in an effort to achieve adequate investor protection. This will also afford the investors in these funds the benefit of being taxed on the same basis as existing non-property collective investment schemes.

“Restricted” funds, by contrast, will be subject to limited access by “sophisticated” investors. While they will be regulation-light, the gains and losses of these restricted funds will be treated as ordinary income on withdrawal from the fund. This relative handicap will no doubt ensure that such funds will become suitable only to those investors who qualify as tax exempt investors – most likely, pension funds.

While the introduction of Retail funds should drive significant growth for the industry, admittedly off a low base, only those managers who can boast the capacity to manage significantly larger investor volumes, as well as the ability to deal daily, will be able to take advantage of this growth. Regulations will also include certain prudential restrictions or asset class limitations, liquidity requirements and leverage constraints.

Overall, the hedge fund industry is teed up in its most expectant position since the first South African hedge funds started trading in 1995. Armed with some of the best investment talent around with proven track records over many years, investors and IFAs may wish to consider this space seriously. In fact, many investors have already gained access to this talent via several collective investment schemes launched by these managers in the CISCA environment to compliment their suite of hedge funds. And these investors have been well-rewarded. While these managers may not have been able to apply leverage and short sell, they have demonstrated superior alpha generation by bringing a hedge mind-set to a market dominated by traditional long only managers.

From a hedge fund perspective the proof is in the numbers. Equity Long Short funds dominate the industry, with more than 50% of industry assets in this category, so for illustration purposes we have focused on this strategy. Managers can go long (buy) stocks that they think will outperform, and go short (sell) stocks that they think will underperform, thereby profiting from both rising and falling stock prices, while reducing the portfolio’s overall volatility and exposure to market risk. The effect of this strategy is to provide returns similar to the All Share Index, but at much lower volatility. It is interesting to note that the Symmetry Long Short Index outperformed all multi-asset funds over the last 5 years, with lower volatility than the Multi-Asset Medium Equity, Multi-Asset High Equity and Multi-Asset Flexible CISCA categories, and with only slightly higher risk than the Multi-Asset Low Equity category.

The case for hedge is apparent and retail hedge funds are finally almost a reality. They encourage long terms savings and provide an exciting alternative to conventional money market and equity funds. With the changes to Regulation 28 and hedge fund regulation on the horizon, there will be little excuse that the right hedge fund strategies be included in most long-term investment portfolios. Could it be that the next Allan Gray or Coronation emerges from a hedge fund industry fighting for superior risk adjusted returns?

Authors:

Mark Preston - Laurium Capital (Pty) Ltd - COO

Kim Hubner - Laurium Capital (Pty) Ltd - Marketing & Business Development