The ability of hedge funds to produce consistent, positive and excess returns is a product of them having less constrained opportunity sets than long-only funds.
Lourens Pretorius, portfolio manager of Amplify Investment Partners’ Sanlam Alternative Vega Retail Investment hedge fund, said these include mandate advantage (having a less constrained mandate), skills advantage (having smart and experienced people) and operational advantage, with access to derivatives, a back-office environment that can cater for derivatives and access to international counterparties. These advantages enable hedge fund managers to have an unconstrained opportunity set to achieve consistent positive returns, said Pretorius. Pretorius has a track record of producing 16% net return per annum over the past 13 years.
“Even more important is the correlation of returns. The correlation to equity is negligible, and the correlation to the bond market is not significant. This is a strong reason arguing in favour of the inclusion of relevant hedge funds into an investment portfolio to get the diversification benefit.”
Pretorius says that at the onset of the pandemic, the declining economic backdrop pointed to a significant loss of government revenue and was expected to lead to a supply of more long-dated bonds and the need for accommodating monetary policy. Generally, a fund manager in these circumstances would like to avoid long-dated bonds and be positioned more in favour of short-dated bonds to benefit from monetary policy accommodation. Traditional bond fund managers can sell the bonds they have and substitute that by buying shorter-dated bonds. A hedge fund manager, however, can short sell long-dated bonds and buy shorter-dated bonds. The hedge fund manager would benefit from the steepening of the yield curve and would pursue a relative value opportunity. They wouldn’t be constrained to merely shift from one area to another of the yield curve but benefit from both areas by selling short at one end and buying at another.
The fund is a fixed income hedge fund and focuses very much on the shorter end of the yield curve, giving it a monetary policy orientation. The fund’s managers believe that the market is a weak predictor of future monetary policy, while South Africa pursues a credible monetary policy framework based on macro variables and the interplay between growth and inflation. In addition, the fund’s manager believe interest rate derivative access vastly expands the opportunity set. “We are provided with directional opportunities to express views, in terms outright levels of monetary policy timing and the magnitude of those changes.”
At the front end of the yield curve, changes in the level and shape of interest rate expectations provide favourable opportunity sets. Knowing South Africa has an orthodox central bank focused on macro variables, it is important for the fund’s manager to look at different outcome scenarios, construct likely monetary policy paths, or repo rate outcomes, over the next two years and predict upside and risk scenarios.
This enables them to look at various dimensions of opportunities and produce a strong positive return highly uncorrelated to traditional asset classes, which renders fixed income hedge funds an ideal diversifier in an investment.
Greater degrees of freedom afforded by long-short equity strategies have also enabled Amplify’s Sanlam Alternative Theta Retail Investment hedge fund to outperform.
Portfolio manager Jonathan du Toit said the fund’s managers are valuation based, with a quality bias. They establish an intrinsic value using a bottom-up research methodology by analysing the business, meeting management, understanding the industry, talking to suppliers and customers so as to determine what they think a business is worth if they had to buy it and own it forever. The fund works on a four-year ranking table, trying to decide what a business will be worth in four years, to establish a four-year exit price. This, combined with a dividend yield, enables it to calculate an internal rate of return and rank shares from the best return to the worst. “Shares at the top we like, and we buy, and at the bottom, we won’t own them, or we will potentially short them.”
The fund uses a proprietary momentum indicator to help size its position and time entry and exit.
The fund also considers that markets can get emotional on the upside and downside, making sure it is positioned that when markets get exuberant on the upside, it can buy more, capture a bit more of the upside, and not sell too early. Positions are appropriately sized through a disciplined risk management process, and the fund aims for many independent positions, limiting exposure to one particular sector or companies exposed to a particular theme, such as the oil price.
Du Toit and his team aim to deliver ALSI plus 10% per year and have achieved 21% a year after fees, beating the ALSI by 10.4% per year and only being behind benchmark in one of the last 10 years with no negative calendar years.
Having hedge fund capabilities has facilitated the high outperformance over the ALSI and is achieved by running 14 different strategies, each aimed at getting a different additional return. Of the 14, only three strategies bear any resemblance to long-only equity strategies.
These long-short equity hedge strategies include protecting the downside using a long fence or bull fence and a strategy on corporate actions, where it assesses the upside and downside and probability of an announced deal going through and calculates a probability of return. The shorting strategy is aimed at not just shorting shares when it thinks they are expensive, as these shares may still have years of market-beating growth ahead but linking shorting decisions to an event.
These are some of the ways hedge funds provide additional opportunities to add returns to the fund. “We have a bigger toolbox than long-only managers, and additional opportunities to add returns to the fund,” du Toit said.
