Strictly private and confidentialFor discussion purposes only

Hedge Funds in South Africaby Peter Urbani

2

•What are Hedge Funds

•Where do Hedge Funds Belong

•What Returns should I expect

Why Hedge Funds

3

What is a Hedge• A hedge is a protective barrier, designed to mitigate or reduce the adverse effects

of something.

In the case of an actual hedge, they are designed to be windbreaks that protect fields and crops from strong winds

4

What are Hedge Funds• An extreme form of unconstrained active management that seek to generate

absolute returns by reducing downside risksCo

mpl

exity

High

Low Costs High

Equities

Index Funds

Cash

Hedge

Structured Products

Bonds

PASSIVE

ACTIVE

Balanced

5

Bi-Lateral (both sides) Symmetry (the same shape)

6

Normal Distribution Assumes Risk Symmetry

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

0.00%

500.00%

1000.00%

1500.00%

2000.00%

2500.00%

3000.00%

3500.00%

4000.00%

-6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00%

Normal

Upside ‘Risk’Downside ‘Risk’ =

7

But real returns often Asymmetric –ve Skewed

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

0.00%

500.00%

1000.00%

1500.00%

2000.00%

2500.00%

3000.00%

3500.00%

4000.00%

-6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00%

Neg- Skew Normal

Upside ‘Risk’Downside ‘Risk’ ≠

8

0.00%

500.00%

1000.00%

1500.00%

2000.00%

2500.00%

3000.00%

3500.00%

4000.00%

-6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00%

Normal Pos+ Skew

A hedged fund should by definition be Positively Skewed

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

Upside ‘Risk’Downside ‘Risk’ ≠

9

Equities versus Equities – Beta = 1.00, Alpha = 0%

If you buy Equities you are exposed to Pure Beta

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Pure

Bet

a

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

ALPHA = 0.00%

ACTUAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

10

Equities versus Equities – Beta = 1.00, Alpha = 0%

When Markets go down you go down by the same amount

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Pure

Bet

a

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

ALPHA = 0.00%

ACTUAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

11

Perfectly ‘Hedged’ Fund – Downside Beta = 0, Upside Beta = 1.0, Alpha = +1.21%

A Perfectly Hedged Fund would protect your downside

ASSUMEDJOINT NORMALDISTRIBUTIONSSYMMETRIC

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Perfe

ctly

Hed

ged

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

ALPHA = 1.21%

THEORETICAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

12

Perfectly ‘Hedged’ Fund – Downside Beta = 0, Upside Beta = 1.0, Alpha = +1.21%

Which would by definition make its returns Asymmetric

ACTUAL JOINTDISTRIBUTIONSBY DEFINITIONASYMMETRIC

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Perfe

ctly

Hed

ged

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

ALPHA = 1.21%

THEORETICAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

13

• Joint Normal Distribution assumption can under- or over- state both positive and negative risks and consequently tail risk and true correlation.

Normal versus Positively Skewed Distributions

-2.00%

-1.28%

-0.56%

0.16%

0.88%

1.60%

2.32%

3.04%

3.76%

0.0000

0.0200

0.0400

0.0600

0.0800

0.1000

0.1200

0.1400

0.1600

0.1800

-4.0

0%

-3.6

8%

-3.3

6%

-3.0

4%

-2.7

2%

-2.4

0%

-2.0

8%

-1.7

6%

-1.4

4%

-1.1

2%

-0.8

0%

-0.4

8%

-0.1

6%

0.16

%

0.48

%

0.80

%

1.12

%

1.44

%

1.76

%

2.08

%

2.40

%

2.72

%

3.04

%

3.36

%

3.68

%

4.00

%

Test Fund

Bad

0.1600-0.18000.1400-0.16000.1200-0.14000.1000-0.12000.0800-0.10000.0600-0.08000.0400-0.06000.0200-0.04000.0000-0.0200

-3.00% -2.04% -1.08% -0.12% 0.84% 1.80% 2.76% 3.72% 4.68%0.0000

0.0200

0.0400

0.0600

0.0800

0.1000

0.1200

0.1400

0.1600

-4.00%

-3.20%

-2.40%

-1.60%

-0.80%

0.00%

0.80%

1.60%2.40%

3.20%4.00%

Good

Bad

0.1400-0.16000.1200-0.14000.1000-0.12000.0800-0.10000.0600-0.08000.0400-0.06000.0200-0.04000.0000-0.0200

14

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Perfe

ct H

edge

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

Perfect Hedge Fund – Downside Beta = 0.30, Upside Beta = 0.70, Alpha = +1.50%

A Perfect Hedge Fund would give you alpha of around 1.50%

ALPHA = 1.50%

THEORETICAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

15

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Med

ian

LS H

edge

Fund

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

Actual LS Hedge Fund – Downside Beta = 0.14, Upside Beta = 0.20, Alpha = +0.70%

Actual Hedge Funds have delivered about half of that

ALPHA = 0.70%

ACTUAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

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-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Top

Qua

rtile

LS H

edge

Fund

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

Top 25% LS Hedge Fund – Downside Beta = 0.12, Upside Beta = 0.32, Alpha = +1.70%

But Top Quartile Funds have delivered more

ALPHA = 1.70%ACTUAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

17

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Top

Deci

le LS

Hed

ge Fu

nd

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

Top 10% LS Hedge Fund – Downside Beta = 0.06, Upside Beta = 0.45, Alpha = +2.95%

And Top Decile Funds have delivered twice as much

ALPHA = 2.95%ACTUAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

18

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Botto

m D

ecile

LS H

edge

Fund

SA Equities

Best Fit Bi-variateCopula Lines

PiecewiseRegression

Linear Regression

Worst 10% LS Hedge Fund – Downside Beta = 0.36, Upside Beta = 0.13, Alpha = -1.36%

While Bottom Decile Funds have not done as badly

ALPHA = -1.36%THIS IS WHAT YOUDON’T WANT TO SEEHIGHER 4TH QUADRANT TAIL DEPENDENCE

ACTUAL

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

19

Impact of Asymmetry on Risk Metrics - Actual

-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00%

Best Fit and Assumed Normal Distributions for Pure Beta

Best Fit Fund PDF (Normal)

Assumed Normal Fund PDF (Normal)

-2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00%

Best Fit and Assumed Normal Distributions for Median LS Hedge Fund

Best Fit Fund PDF (J ohnson (Lognormal))

Assumed Normal Fund PDF (Normal)

Hedge Funds’Equities

20

• Hedge Funds are complimentary assets

Where do Hedge Funds Belong

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

SA Domestic Asset Classes

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

21

Efficient Frontier without Hedge Funds allowed

• Hedge Funds are complimentary assets

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Efficient Frontier Without Hedge Funds

Efficient Frontier Without Hedge Funds ( Normal )

Optimal Without Hedge Funds ( Normal ) Vol = 9.09%

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

22

Efficient Frontier with Hedge Funds allowed

• Frontier with Hedge Funds moves to the left – reducing volatility

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Efficient Frontier With Hedge Funds

Efficient Frontier With Hedge Funds ( Normal )

Optimal With Hedge Funds ( Normal ) Vol = 2.76%

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

23

Hedge Funds are Risk Diversifiers

• Adding Hedge Funds to your portfolio will reduce its volatility

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Efficient Frontier With and Without Hedge Funds

Efficient Frontier Without Hedge Funds ( Normal )

Efficient Frontier With Hedge Funds ( Normal )

Optimal With Hedge Funds ( Normal ) Vol = 2.76%

Optimal Without Hedge Funds ( Normal ) Vol = 9.09%

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

24

Including Hedge Funds leads to better Risk Adjusted Returns

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

-9.00%-8.00%-7.00%-6.00%-5.00%-4.00%-3.00%-2.00%-1.00%0.00%1.00%

Retu

rns (

Mon

thly)

Modified Value at Risk ( VaR )

Mean Modified Value at Risk (VaR) (Monthly) Frontier

Efficient Frontier Without Hedge Funds ( Normal )

Efficient Frontier With Hedge Funds ( Normal )

Optimal Without Hedge Funds ( Normal ) VaR @ ( 99.00% ) = -5.12%

Optimal With Hedge Funds ( Normal ) VaR @ ( 99.00% ) = -1.00%

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

• Hedge Funds are risk diversifiers

25

• Hedge Funds are complimentary assets

Unconstrained Optimal Portfolio mainly in Hedge Funds

26

• Hedge Funds are complimentary assets

But many SA investors subject to Reg 28 Constraints

27

Reg 28 (Prudential Limit) Constrained Efficient Frontiers

• Even with Hedge Funds limited to 10% of your portfolio they still shift the frontier

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Reg 28 Constrained Frontiers With and Without Hedge Funds

Efficient Frontier Without Hedge Funds ( Normal )

Efficient Frontier With Hedge Funds ( Normal )

Optimal With Hedge Funds ( Normal ) Vol = 7.84%

Optimal Without Hedge Funds ( Normal ) Vol = 8.60%

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

28

Impact of Asymmetry on Efficient Frontiers

• Even with Hedge Funds limited to 10% of your portfolio they still shift the frontier

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Mean Modified Frontiers With and Without Hedge Funds

Efficient Frontier Without Hedge Funds ( Modified )

Efficient Frontier With Hedge Funds ( Modified )

Optimal With Hedge Funds ( Modified ) Vol = 7.25%

Optimal Without Hedge Funds ( Modified ) Vol = 7.82%

29

Impact of Asymmetry on Efficient Frontiers

• Standard Mean Variance ( Normal ) Frontier does not capture asymmetry

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Normal Frontier provides innacurate allocation advice

Efficient Frontier With Hedge Funds ( Normal )

Efficient Frontier With Hedge Funds ( Modified )

Optimal With Hedge Funds ( Modified ) Vol = 7.25%

Optimal With Hedge Funds ( Normal ) Vol = 7.84%

30

Asymmetry causes Correlation and Vols to be Different

31

Impact of Asymmetry on Efficient Frontiers

• Standard Mean Variance ( Normal ) Frontier does not capture asymmetry

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

SA Equities

SA BondsSA Cash

SA Property

SA Hedge

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Normal Frontier provides innacurate allocation advice

Efficient Frontier With Hedge Funds ( Normal )

Efficient Frontier With Hedge Funds ( Modified )

Optimal With Hedge Funds ( Modified ) Vol = 7.25%

Optimal With Hedge Funds ( Normal ) Vol = 7.84%

32

Impact of Asymmetry on Hedge Fund Efficient Frontiers

• Standard Mean Variance ( Normal ) Frontier does not capture asymmetry

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

BI Fixed Income

BI LS Conservative

BI LS Aggressive

BI Commodities

BI Structured Finance

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

Retu

rns (

Annu

al)

Volatility (Annual)

Normal Frontier provides suboptimal allocation advice

Efficient Frontier With Hedge Funds ( Normal )

Efficient Frontier With Hedge Funds ( Modified )

Optimal With Hedge Funds ( Modified ) Vol = 1.44%

Optimal With Hedge Funds ( Normal ) Vol = 1.62%

33

Normal ( Mean Variance ) and Modified Optimal Allocations

12.99%

30.00%

13.80%

10.97%

2.24%

30.00%

Optimal Porfolio Weights ( Normal )

BI Fixed Income BI LS Conservative BI LS Aggressive

BI Commodities BI Structured Finance BI Other

0.00%

30.00%

30.00%4.47%

5.53%

30.00%

Optimal Porfolio Weights ( Modified )

BI Fixed Income BI LS Conservative BI LS Aggressive

BI Commodities BI Structured Finance BI Other

34

( Normal ) and ( Modified ) Correlation and Vols

35

Giving much better Risk Adjusted Stats

• Standard Mean Variance ( Normal ) Frontier does not capture asymmetry

Source: Blue Ink Investments, Data from 1 Jan 2011 to 31 Dec 2015

BI Fixed Income

BI LS Conservative

BI LS Aggressive

BI Commodities

BI Structured Finance

BI Other

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

-8.00%-7.00%-6.00%-5.00%-4.00%-3.00%-2.00%-1.00%0.00%1.00%

Retu

rns (

Mon

thly)

Modified Value at Risk ( VaR )

Mean Modified Value at Risk (VaR) (Monthly) Frontier

Efficient Frontier With Hedge Funds ( Normal )

Efficient Frontier With Hedge Funds ( Modified )

Optimal With Hedge Funds ( Normal ) VaR @ ( 99.99% ) = -0.98%

Optimal With Hedge Funds ( Modified ) VaR @ ( 99.99% ) = -0.46%

36

Looking after other people’s money requires both Defensive (Risk Management) and Offensive ( Selection ) skills

37

Hedge Funds should be a key part of your defense

• Including Hedge Funds in your portfolio can help limit downside risks