Can Investors Afford not to invest in Hedge Funds?

October 15, 2014
Kim Hubner, Marketing and Business Development, Laurium Capital

Markets around the world have been in bull-market territory for five years now, with stocks trading at record highs. It hasn’t necessarily been a smooth ride, but long-only investors should have done well enough with buy-and-hold equity strategies in the wake of the big global crash of 2008.Who would have predicted after the devastation of 2008 that markets would bounce back so relentlessly?

It’s the kind of environment that is prompting any reasonable investor to wonder when things might change.

At some point, markets will turn. Some wonder why they have not turned already: current economic data in South Africa is not encouraging, including a muted outlook for GDP growth, rising inflation and increasing debt levels. But other than switching to cash or theoretically low-risk money-market funds, is there a way to protect portfolios when markets turn bearish?

Alternative asset classes, including real estate, private equity and hedge funds, offer a different dimension to investor portfolios that can help add value over time. For example, Laurium Capital, offers a range of hedge funds designed to provide good risk-adjusted returns through different market cycles, including protection from downward swings. Laurium's flagship Long Short Fund launched in August 2008, had a drawdown of only 10.8% (net of fees) by February 2009, the market's low point. By comparison, the ALSI fell 31.8% over the same period on a total return basis. The Laurium Market Neutral fund has generated a return of 12.8% p.a. over 5 years with the biggest ever draw down of less than 2%.Over time, hedge funds have proved that they can add value and diversification benefits. Research from the Alternative Investment Management Association (AIMA), the global body that represents hedge funds, shows that between 1994 and 2011 hedge funds significantly outperformed the main asset classes such as equities, bonds and commodities.

The report, called The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy, commissioned by AIMA and KPMG and published in April 2012, found that, per annum, hedge funds returned 9.07% on average after fees over that 17-year period, compared to 7.18% for global stocks, 6.25% for global bonds and 7.27% for global commodities. And these returns came with considerably lower volatility as measured by value at risk (VaR) than either stocks or commodities and with similar volatility to bonds. Addressing concerns about relatively high fees charged by hedge funds, the report stressed the industry's value to investors by confirming that the large majority of the funds' investment returns went to the investor, rather than the manager.

As a group, South African hedge funds have returned a median annualised 10.94% net of fees in the seven years between January 2007 and December 2013, according to HedgeNews Africa, which tracks monthly numbers from South African managers, vs the FTSE/JSE All Share Index (ALSI) annualised return of 9.23% over the same period (total return 12.4%).When the markets crashed in 2008, South African hedge funds delivered a median +9.03%, according to the HedgeNews Africa South African Single-Manager Composite, when the ALSI fell by 23.23%. The Composite went on to gain 12.32% in 2009, as the South African market bounced 32%.Yes, as a group, hedge funds do not typically keep pace with the equity markets on the upside, although some individual funds may do so. Managers add protection to their portfolios so as to generate positive returns when markets fall. It is also worth noting that In the South African context hedge funds are highly regulated and transparent.Hedge funds also compare favourably to other asset classes. This year to the end of July, the Hedge News Africa Composite has gained 6.52% net of fees, while the ALSI has risen 12.82% (total return), the All Bond Index is 4.42% higher and cash has added 3.28%. Even though hedge funds have delivered lower returns than bullish stock markets in the past few years, big global allocators have been adding to their hedge fund allocations.

According to Deutsche Bank’s 12th annual Alternative Investor Survey, released in February, nearly half of institutional investors increased their hedge fund allocations in 2013, and 57% plan to grow their allocations in 2014.Deutsche surveyed 400 investor entities representing more than US$1.8 trillion in hedge fund assets and over two-thirds of the entire market by AUM. It found that institutional investors now account for two-thirds of industry assets, compared to approximately one-third pre-crisis, illustrating a growing conviction.

So, with some of the smartest investors in the world allocating to hedge funds, and historical data illustrating that they add value, what should investors be doing? At the very least they should consider allocating a portion of their assets to such uncorrelated asset classes, and then begin to do their homework as to those funds and managers that can help protect and grow capital in all market cycles.

Rather than asking: “Can I afford to invest in Hedge Funds?” investors should perhaps instead be asking: “Can I afford not to?

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