Hedge funds are showing their mettle as markets continue to experience significant volatility, uncertainty and poor performances across asset classes due to the coronavirus pandemic. By their nature, these funds are geared towards producing relatively superior risk-adjusted returns regardless of market condition. The proof has not always been in the pudding, but recent statistics have validated their raison d’être, and rewarded investors for their faith in an often overlooked and misunderstood asset class.

A hedge fund allows investors to profit irrespective of whether markets or securities are going up or down. “Considering that, the most defining feature would be the ability to go short a security and additionally use leverage as well as derivatives to eke excess returns in most market environments,” says Marthinus van der Nest, head of Amplify Investment Partners. Amplify also uses award-winning, next-generation managers, who have significant hedge fund experience over multiple market cycles, to manage its long-only unit trusts too.

Investors have been wary of hedge funds, largely due to misconceptions about their risk, past performance of infamous funds and fears that there is not enough regulatory oversight. In reality, hedge fund managers are not that dissimilar to their “long-only” counterparts that invest in securities, bonds and cash. They have the added advantage to make use of additional tools at their disposal such as short-selling, leveraging, and access to derivatives. These tools enable them, in theory, to generate better risk-adjusted returns than long-only funds, thus producing positive returns in both up and down markets which in turn allow hedge funds to produce returns that are uncorrelated to those of other asset classes.

Recent statistics demonstrate that hedge funds are proving their worth against the performance of traditional asset classes, particularly given the turmoil markets have been facing in 2020. An equally weighted portfolio of four of Amplify’s Fixed Income Hedge Funds returned 9.20% growth for the year to end of April 2020 against a 10.4% decline in the JSE All Share index, a 5.14% decline in the All Bond index. Over a year, the blended portfolio grew 18.1% against the All Share’s decline of 10.78% and a marginal growth in the All Bond index. Over three years, the picture is similar, with the blended portfolio showing 13.5% annualised growth compared to the All Share’s marginal 1.08% growth and the All Bond and STeFI growth of just over 6%.

“During events that create volatility, like those over the past few months, the prices of securities deviate from the prices that make fundamental sense,” says Van der Nest. “This is when long-only managers tend to perform poorly.”

“Hedge fund managers, on the other hand, had the opportunity to profit from this pricing dislocation by going long the overvalued security and short the undervalued security either in the equity or fixed income market,” he says. “The same opportunities can also be expressed using derivatives, albeit at higher risk.”

Hedge funds use derivatives, which offer “a vast set of opportunities that normal long-only funds could never access” while leverage enables them to generate returns on borrowed funds.

“Of course, these capabilities come with their own risks, which is why it is so important for hedge funds to have proper risk mitigation processes as well as for regulation,” says Van der Nest.

While trusted and well-established hedge funds continue to have exemplary risk management processes in place, regulatory oversight has also improved with the separation of Retail Investor Hedge Funds (RIHFs) which have stringent liquidity and leverage constraints, and Qualified Investor Hedge Funds (QIHFs) for more complex investment and a wider risk profile.

Because of the nature of hedge funds, and investors’ ability to understand risk, Regulation 28 limits hedge fund exposure to 10% for pre-retirement portfolios.

“The extent of exposure to hedge funds is obviously client-specific,” says Van der Nest. “Hedge funds aim to produce superior returns on a risk-adjusted basis. When all is said and done, an investor is trying to maximise his return at the lowest possible risk, especially when the market is performing badly.”

Long-only multi-asset funds try to achieve that by diversifying risk between equities, property, bonds and cash, local and offshore.

The uncorrelated nature of hedge funds offers an additional source of diversification, significantly improving the overall risk profile of a broader portfolio.

Amplify presents eight distinct retail hedge funds specialising in multi-strategy, equity and fixed income, hedge funds, and it is looking to add more. “The hedge funds that are selected are the result of a rigorous research process,” Van der Nest says. “We consider the entire hedge fund market and scour the pool for the most skilled, most consistent performers, not only with superior performance over a sustained long enough period to prove their investment skill but with robust risk management and portfolio construction processes as well.”

While hedge funds may have been poorly understood in the past, the industry has been increasingly transparent about its processes, strategies and its risk management, and Van der Nest believes investors are becoming more receptive.

The perception of high fees has also been a deterrent for investors, but fees have come down. Most hedge funds charge performance fees and would typically be more expensive than traditional long-only managers, especially if performance fees kick in. Performance is, however, quoted net of fees, so investors know what they are getting. Market forces in the future will probably lead to fees lowering further,” he says.

With living annuities, low market returns over the last five years have placed considerable strain on portfolios while clients are drawing an income. “The fact that hedge funds have the ability to protect investors on the downside while providing clients positive returns makes them a perfect addition in the portfolios of these clients,” says Van der Nest.

If the relative outperformance of the past few years is any indicator, an increasing number of investors could be looking to hedge funds to bring some light to the current gloom.

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