12 A u g u s t V o l u m e b y G l a c i e r R e s e a r c h

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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h Introducing Hedge Funds and why sometimes what appears complex is indeed the simple solution Written by: Bonolo Zwane, Managing Director for Sanlam s fund of hedge fund business, Blue Ink. 12 A u g u s t V o l u m e 8 74 It has become an Internet meme of note that two characters which make up the Chinese word for Risk or Crisis consist of the characters for Danger and Opportunity. Although not strictly correct, the two characters can be separated this way. For the purpose of this article, we will accept the premise because it nicely illustrates the point we wish to make, which is that Risk and Reward are two sides of the same coin but not always equal. To answer what appears to be a very philosophical conundrum, it is sometimes easier to bring it back to 101 principles. We therefore introduce a simple discussion of risk and reward concepts and how this relates to money management. In particular, with the recent promulgation of regulated hedge funds in South Africa, investors are becoming increasingly more aware of these additional strategies and their investment appeal in solving some of these simple but often competing investor requirements. In finance the accepted, but by no means only, measure of Risk is Standard Deviation (often called Volatility). This is one possible statistical measure of dispersion sometimes also called variability, scatter, or spread. It thus seems that the spread of how far apart the returns are is important to us. Why? - because the further apart things are, the wider the dispersion and the more uncertain we are about where we will end up relative to the true mean or average. Page 1

2 At the risk of introducing technicalities, the frequent criticism of Volatility is that it depends on just the mean and variance of your returns. The assumption is made that returns are symmetrically distributed about the mean. In other words that the proportion and magnitude of negative returns are assumed to be equal to those of positive returns. Alternative empirical measures of dispersion like the Min and Max and Interquartile Range do not make this assumption. Appreciating this technicality is crucial as rational investors do not consider positive returns to be undesirable. Rather, they see upside risk as a positive and downside risk as a negative. If you wish to reduce your risk and use Volatility as your measure then you will simply pick assets with less variable returns like cash and bonds rather than say, equities. But in so doing, and if you accept that upside return potential is good and not bad risk, then you will be limiting your upside Opportunity by doing so. To get the best of both worlds then, limited downside risk and maximum upside risk, one should look for assets or groups of assets that have a wider dispersion to the upside than the downside i.e. whose distribution of returns is asymmetric. Hedge Funds have historically claimed and, in the South African context, proved to offer such an opportunity set where this is the case. The reason being that Hedge Funds are by design trying to protect capital in environments where risk is penalised, while they grow wealth in environments where opportunities present themselves. Moreover it important to note that Hedge Funds are not a homogenous asset class in the same way that Equities, Properties and Bonds are. Rather they are a collection of diverse investment strategies which employ one or more of the other asset classes plus the ability to short sell and or apply leverage. It therefore also implies that strategy selection is that little more difficult and should require careful consideration. The main strategies employed within this space are Long Short Equity (which we separate into two subsectors being Aggressive and Conservative), Fixed Income Arbitrage, Multi Strategy and Commodities. Although somewhat familiar in naming conventions to traditional investments, the strategies employed are significantly different and descriptions of which we reserve for a follow-up piece to this article. In the set of analytics below we provide an overview of the historical net-of-fee performances of some of the average strategies and how this compares with traditional investments. Page 2

3 Figure 1: Cumulative Return of Hedge Funds versus Traditional Indices (31/10/2001 to 31/05/2016) Figure 2: Risk Return Scatter of Hedge Funds versus Traditional Peers (31/10/2001 to 31/05/2016) Page 3

4 The investment argument for hedge funds is indeed compelling and appeals to both the risk and return objectives of the investor. We are confident that over the next few months as these strategies become more mainstream, these charts will become more familiar. Despite, the lower Volatility measures of hedge funds, we present Figure 3 where risk is not defined by Volatility, but rather by the dispersion of returns that reflect both the upside potential as well as the downside risk of the different strategies. Figure 3: Dispersion of Fund Returns within each Peer Group (31/10/2001 to 31/05/2016) For example South African General Equity Unit Trust funds had five year total returns ranging from minus 9% to plus 244% for the five years to end May 2016 while LS Aggressive Hedge Funds had returns ranging from plus 28% to plus 403% over the same period. This simple observation is indicative of the upside opportunities of the different strategies coupled with their downside protection that is also offered. It is thus evident that Hedge Funds offer a range of different risk and return exposures and a broader opportunity set than classical asset classes. With a proud track record of delivering on both of the competing objectives of risk and reward, the strategies indeed merit an investigation and understanding for potential use in broad balanced fund portfolios. Page 4

5 Disclaimer: Blue Ink Investments (Pty) Ltd is an authorised financial services provider in terms of the Financial Advisory and Intermediary Services Act. The information in the article does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. Collective investment schemes are generally medium- to long-term investments. Please note that past performances are not necessarily an accurate determination of future performances, and that the value of investments / units / unit trusts may go down as well as up. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Glacier Research would like to thank Bonolo Zwane for her contribution to this week s Funds on Friday. Bonolo Zwane, BSc. (Actuarial Science), Diploma in Actuarial Techniques After completing her tertiary education at the University of the Witwatersrand, Bonolo began her 12 year career in financial services at Alexander Forbes. She went on to join Stanlib where she held a number of investment and business related roles including business development and client retention, quantitative investment analysis and portfolio management. Bonolo joined Blue Ink Investments in 2015, where her current role is Managing Director. Page 5