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November 22, 2005
South African retail investors get hedge fund access
Retail investors in South Africa will soon get the opportunity to invest directly in a limited range of hedge funds. Jurgen Boyd, who is in charge of the regulation of collective investment schemes at the Financial Services Board (FSB), says the industry aims to allow the introduction of regulated retail hedge funds by the end of the first quarter of 2006.
It was widely expected that the first funds to be approved would be funds of hedge funds, which would allow investors to spread their risk between a number of funds carrying out different strategies.
But Boyd says the first stage is to regulate the underlying funds. They will be allowed to invest in the same instruments as traditional collective investment schemes (unit trusts), including all listed shares, bonds and derivatives. But over-the-counter derivatives will not be permitted, and there will not be scope to launch funds in popular categories of hedge funds such as commodities and currency trading.
Unlike markets such as the US, there will not be a special category in SA called the qualified investor. With US$1m of investable cash, these investors are considered sophisticated enough to invest in hedge funds. In SA all retail investors, whether they are investing R200/month or a R1m lump sum, will be treated equally.
"It is not appropriate, with our history, to have first- and second-class investors," says Boyd. "And it is wholly arbitrary to say that an investor with R3m or R5m is financially sophisticated. What about someone who retires with a large lump sum but has no experience at all of investments?"
Retail investors would have been exposed to hedge funds through funds of funds wrapped in a five-year endowment. This is a regulatory loophole as the FSB does not regulate life companies at product or portfolio level, but concerns itself primarily with the solvency of the life office. The only stipulation is that hedge fund products are ring-fenced so that in the event of meltdown the losses do not contaminate the rest of the policyholders. The majority of these have been a basket of offshore hedge funds: Coronation, Charter Life (now Liberty Active) and Old Mutual International have been the biggest promoters of these products.
Unfortunately these funds have not provided attractive returns recently, but this is entirely due to the strength of the rand. In the three years to August 2005, the World Absolute Return Fund, run by Ivy Asset Management and sold by Old Mutual, has provided a negative 8,9%, though in dollars it was a quite respectable positive 7,1%, substantially better than a cash investment, and at much lower volatility than the equity market - 2,4% compared with 13,1% from the equity market. Ivy's Long/Short Equity fund has given a 10,4% return.
There are also already a number of hedged funds which appear in the domestic hedge fund databases, such as Allan Gray Optimal. It hedges out the market risk with futures so that the investor earns cash returns plus the excess returns Allan Gray can generate.
But recently this fund and competitors such as RMB Absolute Focus have not provided anything like the returns available from domestic hedge funds.
Optimal is in the market-neutral category of the Nedgroup Hedge Fund Review, but with a return of 7,3% over one year and 6,9% over two years it has lagged behind all the funds in its category as well as all the major asset classes in SA.
The track record of the domestic hedge fund sector to date indicates that the local industry is capable of delivering strong risk-adjusted returns.
According to the Nedgroup survey, the long/short equity category, in which most of the new regulated hedge funds will operate, has provided a 38,4% return with a standard deviation of 10%, or about half that of the market.
The more conservative market-neutral category has provided a return of 18% within volatility of 5%.
African Harvest Alternative Investments head Simon Peile says retail investors must be realistic and not expect returns of this magnitude. "Many of the most skilled managers will not offer retail products as they can raise as much money as they need through unregulated funds which operate through private partnerships. These products should be seen as hedge funds lite and will be launched primarily by large institutions to gather assets."
Some of the hedge funds in the Nedgroup survey showed exceptionally strong returns when they started life with R50m, but as the number of hedge funds increases, the opportunities to achieve such high returns diminish as there are fewer market inefficiencies to exploit. In the long term, investors must expect SA hedge fund returns to move closer to those in international markets - in which real returns of 3%-6% after fees are considered realistic.
But hedge funds will still play a useful role in most people's portfolios as their returns are uncorrelated with equities or bonds - if they are doing their job properly they should provide positive returns in all market conditions.
Kevin Shames, head of hedge funds at Alpha Asset Management, says the quality of regulated hedge funds is actually likely to be lower than unregulated funds. "Only those managers who are struggling to raise money will have an incentive to launch regulated funds. As a fund of funds manager I might consider disinvesting from a manager who decided to go the regulated route as he would have to concern himself with the added administrative burden of running a fund that is open to the public."
The FSB is not keen for regulated hedge funds to be treated that differently from mainstream unit trusts - it will allow shorting of shares and for funds to leverage (borrow money) and it will also insist that there is limited liability - because of leverage, investors in hedge funds can lose more money than they put in, but in regulated funds the fund manager will have to indemnify clients against this.
Morn Marais, CE of Tantalum Capital, a hedge fund launched on June 1, says he is unlikely to launch a regulated fund as he has been able to collect the assets he needs through the institutional market. "The only inducements would either be that our clients forced us - but it looks as though the FSB is quite comfortable for an unregulated hedge fund industry to operate in parallel with the regulated one - or if there were certainty that regulated hedge funds had the same tax treatment as unit trusts."
Many hedge fund managers, such as Marais and the colleagues he brought with him from Coronation, left the long-only investment industry to get away from the rat race of public unit trusts and to operate with a lower profile.
The development of regulated hedge fund products has been slow in the rest of the world - just 10 have been registered so far in Germany, a pioneer of the process in the EU.
The UK branch of the Alternative Investment Management Association (AIMA) recently said that the majority of its members had no interest in moving into the retail market as most did not need or want the perceived complications of dealing with retail money.
But it argues that hedge fund products nonetheless remain appropriate for the retail investor: a fund of hedge funds is far safer than a conventional fund which invests in derivatives.
Boyd says that the second phase in the development of regulated products will be the introduction of foreign and domestic funds of funds. "But we only accept funds that are domiciled in jurisdictions in which the regulator is as strong as SA's or stronger. Funds will have to be transparent and that is not negotiable. "
AIMA SA chairman Ian Hamilton says it is essential that there are fit and proper requirements on intermediaries which are more rigorous than those required to distribute conventional funds, and that hedge fund managers have special qualifications.
It is critical that all investors in hedge funds understand the nature of the risks they are taking on, and whether they are appropriate for their financial circumstances.
-Financial Mail-
Posted by su at November 22, 2005 2:05 PM