What do hedge funds hedge?

The definition of what a hedge fund is is still ambiguous, to say the least. South Africa’s Financial Services Board classifies a hedge fund as an investment in which the investor can lose more than what was invested. With that sort of misunderstanding it’s no wonder the word “hedge” fund remains perplexing in the eyes of many investors.

However, in SA, hedge funds have done remarkably well, outperforming all other asset classes since early 2000, when the industry started here. In 2007/2008, hedge funds also protected their investors from most of the downturn experienced in the markets.

Yet the misconception continues. So what’s meant by the term “hedge” in hedge fund and how were SA’s funds able to protect their clients? The very need for a “hedge” implies protection is created against “something”or that "something" is being added or kept.

The “something” referred to by the hedge in investment markets could refer to any one (or a combination) of the following:

* Protection against downside risk or drawdowns.

* Protection against volatility.

* An improvement of the return distribution.

* A quest for alpha.

* Access to return strategies (alternatives) not permitted by regulation.

This article investigates each of the topics above, focusing primarily on their application to SA’s hedge fund industry.

Throughout this analysis the Blue Ink Hedge Fund Composite which monitors the return of all hedge funds since 1999, will be used as a proxy for the hedge fund industry.

Downside protection and drawdown

In order to measure whether the hedged nature of hedge funds does in fact reflect protection of investor interests against downside or drawdowns in returns, the average negative monthly returns and worst monthly return of hedge funds are compared to the ALSI, ALBI and to several of the unit trust industry sector median returns. The average number of negative months (drawdown) and the total number of months for the period January 1999 to April 2010 are also compared.

From Table 1 it can be seen that both the hedge fund composite – the fund of hedge funds (FOHF), as well as the sub-strategies of the hedge fund composite (MN, FI, LSND & LSD - see note*) – all provide better protection against drawdowns than can be achieved by investing in the ALSI or ALBI or in many of the unit trust sectors.

The data also shows that these strategies spend less time in drawdown than many unit trusts or indices.

Volatility, risk and return

While some investors are less concerned about short-term drawdowns, they should rather be more concerned with volatility over the longer term. Once again our research showed that hedge funds tend to be at the lower end of this spectrum if measured over the period since January 1999.

However, it would probably be unfair to consider volatility and drawdown in isolation. Rather we should compare risk to return. Graph 1 confirms that over the period analysed, hedge funds have also provided superior risk/return characteristics.

The quest for alpha

Alpha is probably the most ambiguous characteristic when considering hedge funds or comparing hedge funds to either indices or unit trust sector median returns. While many asset classes and unit trusts alike will claim to be producing alpha over shorter periods of time, (Jensen's alpha – outperformance of the market), very few funds have been able to do that consistently over the longer term.

Graph 2 shows that while most hedge funds have been able to show consistent alpha generation over the past 10 years against the ALSI and the ALBI, very few unit trust sector funds have been able to do the same against both the ALBI and ALSI.

Different return strategies

Hedge funds generally have the ability to apply a host of strategies in their investment strategies that would normally be restricted or prohibited by regulation in a unit trust or Regulation 28 environment.

The first of those is the ability to short sell stocks. That can be done on a pairs basis, buying one security and selling (shorting) another to create a zero net exposure. Alternatively, they could have a negative view on an area of the yield curve and could place an outright short on that security, which could be funded by margin, script or a repo.

The second tool in their armoury is the ability to gear or leverage their portfolio. Again, that’s done by means of using margin, CFDs, script or a repurchase agreement.

The last tool, more commonly referred to as alternative beta trades, refers to activities that would take place in non-traditional markets generally restricted or prohibited by normal CISCA or Regulation 28 rules. That could be any or a combination of:

* OTC trades.

* Derivative exposures to asset classes not commonly catered for in current regulations.

* Instruments not commonly available on SA exchanges.

In general, investors in hedge funds monitor two metrics very closely. The first is the net exposure and the second is the gross exposure of the fund.

* The net exposure gives an indication of the directionality in a fund and its general view on the market. Market neutral funds will typically have a net exposure of zero, suggesting the long and short positions net each other out.

* The gross exposure is a measure of the leverage or gearing employed by a fund [longs + abs(shorts))/fund value].

Our research shows that most managers are on average not fully exposed to the market and will have around 75% of their portfolios’ directionality hedged out with short positions, with only around 25% exposure to the market remaining. Occasionally managers will go net short of the market (ie, have a negative directional view on the market).

Graph 3 further illustrates the extent of gearing in the hedge fund market. Of the 17 equity managers monitored, the average leverage varies between 1 and 1,5 times. Some managers do from time to time extend their leverage as high as 3,5 times.

In short, directional (net) exposure and leverage are used extensively by hedge fund mangers to hedge risks and exploit opportunities.

Conclusion

So what do hedge funds really hedge? The analysis would seem to show the hedging or trading style of hedge funds has the result in the improvement of downside risks and improving the risk return characteristics, as well as the return distribution characteristics of an investment. Hedge funds in SA have made positive contributions with regard to alpha over the past 10 years, while the brief analysis on exposures shows hedge fund managers do indeed short the market and use the alternative tools at their disposal.

We believe, though, that regulatory uncertainty around hedge funds has made many investors shy away from a strategy that has the potential to add a much needed element of diversification to funds.

* Note:

Hedge fund sub categories are defined as follows:

Market neutral (MN) strategies Funds that maintain a net exposure of zero at all times. Long/short non-directional (LSND) strategies are defined as hedge fund strategies that employ a net exposure varying between -40% and 40% at all times.

Long/short directional (LSD) strategies are defined as hedge fund strategies that employ a net exposure of -70% to 100% at all times.

Fixed interest strategies (FI) are defined as hedge fund strategies that employ strategies only within the interest rate environment.

Thomas Schlebusch

Blue Ink

SCHLEBUSCH holds a master’s degree in engineering, plus an MBA from Nijenrode University in the Netherlands. He worked as a commodities analyst at SA Breweries before joining Sanlam Investment Management as part of its bond team. He managed several absolute return funds and inflation-linked fund mandates. At SIM he was also instrumental in developing absolute return fund strategies. He joined the Blue Ink team in 2007 to head its incubation drive within the group.