Question

My son says that we should be investing in hedge funds as it will reduce the amount of risk in our investment portfolio. I’m a bit worried about this as I have seen stories where people have lost all their money in scams like Bernie Madoff’s hedge fund.

Am I being overly cautious?

Answer

Hedge funds are becoming increasingly popular in South Africa so this question will be relevant to many people.

 What I will do is

• give you an overview of what hedge funds are
• show you how to evaluate the risk of a hedge fund
• share some ideas on how they could be used in your investment portfolio
• tell you what you need to watch out for with hedge funds.

Hedge funds are different to normal investments as they use sophisticated financial structures to generate returns or remove risk from a portfolio.  They could, for example, buy options to protect the portfolio against a fall in the market or use short selling to profit from a share that is falling.  They could also use mismatching in pricing to generate better fixed interest returns. 

The strategies followed by these fund managers are quite technical and require a high level of expertise. The challenge for us is to determine whether these strategies can add value to our investments or whether they will be exposing it to unnecessary risks.

Risk

In South Africa, the hedge funds are strictly controlled through an act of parliament and are overseen by the financial sector conduct authority.  The local controls are a lot stricter than that which you would have in other countries.

To ensure that the hedge funds do not unnecessarily expose clients’ money to excessive risk, the funds need to meet one of the following criteria.

• The leverage limit must be less than 200% of the net asset value. In many other countries, this limit is 800%. 
• The value at risk (VAR) must be less than 20%. For example, if a hedge fund has a VAR of 15%, it means that there is a 99% chance that you will not lose more than 15% of your investment in a month.

So, when it comes to evaluating the risk of a hedge fund, you should look at these numbers (the leverage limit or the VAR).  The lower they are the less risky they are.

The naming conventions of hedge funds are different from normal investments. You come across terms like long-short equity, fixed income, multi strategy or market neutral.  With the regular investments, your risk continuum usually runs from the money market to equity or income to growth.  With the hedge fund, you can have income funds being extremely volatile because of the way they are managed.  You must therefore look at how the hedge fund is classified in terms of their risk level and look at measures like the leverage limit or VAR.

Benefits of hedge funds

Because hedge funds use different financial instruments, they often behave differently to regular investments. This can offer a level of protection especially when the markets are very volatile.  When used correctly, hedge funds can reduce the risk in a portfolio and improve returns.

Last month, we saw the JSE drop by 9% and only to finish the month 2% in the positive.  By having hedge funds in the mix, you can reduce this type of behavior in your portfolio. 

Hedge funds can also produce an excellent return with a very low risk profile.  As these returns are not in the form of interest, they do not trigger normal income tax, instead they will be taxed as capital gains.  If you have a portfolio that is attracting a lot of interest income that is taxable then you could consider adding a hedge fund to the mix to reduce this tax liability without having a material impact on the risk of the investment.

Be careful

Because the structures used in hedge funds require a high level of expertise to manage them, these investments are often quite expensive.  Many hedge funds apply a performance fee if the portfolio outperforms a certain threshold. As a result, when you look at fee structures of investments that use hedge funds you can see a large amount applied to investment charges. Just remember that the quoted returns are after these investment fees have been deducted.

Not all financial advisors are allowed to advise on hedge funds as this is quite a sophisticated field. Before you make any hedge fund investments, check that your financial advisor is suitably licensed to provide you with this type of advice.