Financial Analysis and Portfolio Management  

Honours Long Essay:

“Analysing the South African Hedge Fund Industry in a Global

Context”  

Nicole Winckler

WNCNIC001

August 2015

Supervisor: Dr Gary Van Vuuren

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Declaration

Name: Nicole Winckler

Student Number: WNCNIC001

Course: Financial analysis and portfolio management

Declaration

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one’s own.

I have used the Harvard convention for citation and referencing. Each contribution to, and

quotation in, this report from the work(s) of other people has been attributed, and has been

cited and referenced.

This report is my own work.

I have not allowed, and will not allow, anyone to copy my work with the intention of passing

it off as his or her own work.

Signature ______________________________

Date __________________________________

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Abstract Hedge funds have gained popularity and grown exponentially since the 1990s. The intention

of this research paper is to give an overview of the global and South African hedge fund

industry and put forward reasons as to why the South African hedge fund industry assets as a

percentage of long only assets are so small relative to the global asset management industry.

The global hedge fund industry is examined over a period of 18 years to illustrate the

performance over the long run. As the South African hedge fund industry is relatively new,

this study compares results obtained for the global and local industry over a shorter period of

eight years.

This paper provides evidence that the South African hedge fund industry has performed

better than its international peers and has produced superior risk-adjusted returns when

compared to other South African long only equity asset classes. Although high fees

characterise the hedge fund industry in South Africa, they are not as high as their global peers.

Despite strong performance net of fees, asset consultants in South Africa have been reluctant

to recommend hedge funds due to the high absolute level of fees relative to traditional unit

trust structures. Furthermore, the hedge fund industry in South Africa is unique as regulations

have been much stricter than those applicable to the global industry. The results obtained in

this paper also show that the size of the South African hedge fund industry has been limited

due to regulations, the investor base and the conservative nature of South Africans.

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Table of Contents Declaration ................................................................................................................................ 1

Abstract ..................................................................................................................................... 2 List of Figures ........................................................................................................................... 4

List of Tables ............................................................................................................................ 5 Introduction .............................................................................................................................. 6

Chapter One - Overview and Literature Review .................................................................. 8 1.1. What is a Hedge Fund? ............................................................................................. 8

1.1.1. Definition ................................................................................................................. 8 1.1.2. Characteristics .......................................................................................................... 8 1.1.3. The Benefits of Hedge Funds to Investors ............................................................. 10

1.2. The Evolution of Hedge Funds ............................................................................... 10 1.2.1. Origin of Hedge Funds ........................................................................................... 10 1.2.2. Global Hedge Fund Growth ................................................................................... 10 1.2.3. South African Hedge Fund Growth ....................................................................... 12 1.2.4. Evolution of the Investor Base ............................................................................... 15 1.2.5. Evolution of the Strategies ..................................................................................... 17

Chapter Two - Data and Methodology ................................................................................ 19 2.1. Performance of Hedge Funds ................................................................................. 19

2.1.1. Hedge Fund Returns .............................................................................................. 21 2.1.2. Risk-Return Relationship ....................................................................................... 21 2.1.3. The Sharpe Ratio .................................................................................................... 22

2.2. Hedge Fund Fees and Regulations ......................................................................... 22 Chapter Three - Data Analysis and Results ........................................................................ 24

3.1. Hedge Fund Performance ....................................................................................... 24 3.1.1. Returns Analysis .................................................................................................... 24 3.1.2. Risk-Return Analysis ............................................................................................. 26 3.1.3. Sharpe Ratio Analysis ............................................................................................ 28

3.2. Hedge Fund Fees ...................................................................................................... 30 3.3. Hedge Fund Regulations ......................................................................................... 31

3.3.1. Global Regulations ................................................................................................. 31 3.3.2. South African Regulations ..................................................................................... 32

3.4. Results ....................................................................................................................... 35 3.4.1. Qualitative Factors – Nature and Sophistication of Investors ............................... 35 3.4.2. Quantitative Factors – Hedge Fund Returns .......................................................... 35 3.4.3. Combined Factors – Fees and Regulations ............................................................ 35

Chapter Four - Conclusion ................................................................................................... 37

Bibliography ........................................................................................................................... 39 Addendum .............................................................................................................................. 42

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List of Figures

Figure 1: Growth of Global Hedge Fund Assets (US$ Billions). ............................................ 11 Figure 2: Geographical Breakdown of the Global Hedge Fund Industry in 2014. .................. 12

Figure 3: Growth of South African Hedge Fund Assets (R Billions). ..................................... 13 Figure 4: Global hedge fund assets as a percentage of total pension fund assets in 2014. ...... 15

Figure 5: South African hedge fund assets as a percentage of South African pension fund assets in 2014. .......................................................................................................................... 15

Figure 6: Breakdown of Global Hedge Fund Investors in 2014 .............................................. 16 Figure 7: Breakdown of South African Hedge Fund Investors in 2014. ................................. 17

Figure 8: Breakdown of Global Hedge Fund Strategies in 2014. ............................................ 18 Figure 9: Breakdown of South African Hedge Fund Strategies in 2014. ................................ 18

Figure 10: The Returns of Global Assets from 1997 to 2014. ................................................. 24 Figure 11: The Returns of Global Assets from 2007 to 2014. ................................................. 25

Figure 12: The Returns of South African Assets from 2007 to 2014. ..................................... 26 Figure 13: Global 18-year Annual Risk-Returns (1997-2014). ............................................... 27

Figure 14: Global eight-year Annual Risk-Returns (2007-2014). ........................................... 27 Figure 15: Annualised risk and returns for the South African industry from 2007 to 2014. ... 28

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List of Tables

Table 1. Annualised Sharpe Ratios for the Global Industry. ................................................... 29 Table 2. Annualised Sharpe Ratios for the South African Industry. ....................................... 30

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Introduction The aim of this paper is to analyse the question of why the South African hedge fund industry

assets as a percentage of long only assets are much smaller relative to the global asset

management industry. This paper attempts to assist investors and the financial community in

their understanding of South African hedge funds. It aims to present evidence and provide

reasons as to why there has been limited growth in the South African hedge fund industry.

Hedge funds as an investment were first developed in 1949 (AIMA, 2009). Globally hedge

funds have become a progressively popular asset class since the 1990s and have been one of

the fastest growing sectors of the financial services industry (AIMA, 2007). Hedge funds can

be categorised as a non-traditional, alternative investment that offers a different risk and

return profile in comparison to the more traditional investments such as stocks and bonds

(Stefanini, 2009). The main objectives of hedge funds are to preserve capital, limit risk and

provide absolute returns to investors in both bull and bear markets (Hubner, 2014).

Characteristics common among hedge funds include the use of leverage and short selling,

larger flexibility in their trading, charging a management fee and performance fee, generally

unregulated and usually structured as a partnership (AIMA, 2007). However, although there

are commonalities amongst hedge funds, they are not a homogenous investment class and the

way in which they invest their money differs greatly.

The global hedge fund industry is examined over a period of 18 years to illustrate the

performance over the long run. As the South African hedge fund industry is relatively new,

this study compares results obtained for the global and local industry over a shorter period of

eight years, commencing in 2007. The monthly returns for the South African hedge fund

industry were obtained from HedgeNews Africa and the global long/short equity index was

obtained online from EDHEC-Risk Alternative Indexes. The historical monthly index prices

were sourced from the Bloomberg terminal at the University of Cape Town for the rest of the

relevant indices used in this paper.

A variety of different sources were used in order to gather wide-ranging information on the

hedge fund universe. The various research methods included gathering primary data through

three interviews with people involved in the hedge fund industry, which greatly contributed

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to the research process. Secondary data and information for this study were gathered from

books, surveys, articles, journals and the Internet.

This paper comprises of four parts. The first part of this paper introduces the nature of hedge

funds, their main characteristics and their purpose in investment portfolios. This section

includes a literature review of the definition and characteristics of hedge funds and the main

benefits to investors. Furthermore, it gives a brief insight into the history of hedge funds and

analyses the evolution of the global and South African industry. The growth in hedge fund

assets under management (AUM) is analysed as well as the evolution of the investor base and

key trends and developments.

Section two describes in detail the data and methodology used in order to do the analysis and

determine the reasons as to why the South African hedge fund industry is a small percentage

of long only funds compared to the global industry. The methodology explains the path taken

in order to compare the hedge fund industry to other assets in both the global and local

industry. Furthermore, the limitations of these data are briefly discussed in this section.

The third part of this paper critically analyses why South African hedge fund industry assets

as a percentage of long only assets are so small relative to the global asset management

industry. The focus of this analysis is on the high fees that characterise the industry, the

performance of hedge funds when compared to the performance of other asset classes and

finally the regulatory framework that characterises the industry. The performance of hedge

funds is analysed by examining hedge funds returns, risk-return relationships and risk-

adjusted returns in both the global and local industry. The results are then shown and

critically analysed in this section.

The final part of this paper provides an overall conclusion on the South African hedge fund

industry and the main reasons as to why there has been limited growth when compared to the

global industry. Furthermore, possible areas for future work are provided in this section.

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Chapter One -Overview and Literature Review

1.1. What is a Hedge Fund?

1.1.1. Definition

A “hedge fund” is a term that is applied to a heterogeneous group of investment funds and is

used to define a diverse group of financial institutions that play an important role in the

financial system (Stefanini, 2009). A hedge fund is defined as a highly specialised and

managed portfolio that uses pooled funds and makes use of various strategies in order to

generate high risk-adjusted returns for investors. The “hedge fund” term originated from the

hedging techniques that were traditionally used by managers (AIMA, 2007).

Hedge funds initially attempted to reduce risks by ‘hedging’ their investments in order to

produce greater returns for their investors irrespective of whether there were any ups and

downs in the market (AIMA, 2007). Hedge funds are generally arranged as a private

partnership, trying to attain greater risk-adjusted returns in all market environments (Fung &

Hsieh, 1999). Hedge funds currently use a variety of different strategies that each entail

specific risk and return profiles and thus cannot only be said to hedge risk.

According to Stefanini (2006), managers invest in an exceptionally diversified and wide

range of strategies in order to maximise returns and cushion risk. A fund can make use of a

single strategy or a number of different strategies for managing risk, flexibility or for

diversification. Hedge funds tend to use substantial leverage, usually holding both long and

short positions in order to produce high risk-adjusted returns in the global and domestic

markets (AIMA, 2007).

1.1.2. Characteristics

The literature on hedge funds has grown dramatically since the 1990s. The Alternative

Investment Management Association (AIMA) provides information on hedge funds and aims

to increase investor education and transparency. In the literature, hedge funds are generally

defined by their common characteristics rather than a precise definition. There are several

common characteristics shared by the majority of hedge funds that distinguish them from the

more conventional investment funds.

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Hedge funds have greater flexibility in their ability to invest and managers are free to use a

variety of financial instruments unlike traditional funds (AIMA, 2007). They are designed to

protect and grow money even when market conditions are weak and they can make use of

both long and short positions to achieve this. Managers are able to use leverage, which is

often restricted for other investment types such as mutual funds (Fung & Hsieh, 1999).

Hedge funds are able to find protection from falling markets by employing different

strategies in order to achieve positive returns. Each strategy is designed to take advantage of

certain recognisable opportunities in the market (Crockett, 2007). Managers seek to generate

absolute returns, which differ from traditional funds that seek to generate returns relative to a

benchmark (Stefanini, 2006).

Hedge funds are lightly regulated and taxed in the global industry. According to Coggan

(2010), they are not required to report their activities to the general public and transparency

therefore remains an issue amongst them. Managers may want to protect information

regarding their strategies from competitors as it may impact the fund’s returns (Coggan,

2010). Hedge funds tailor to sophisticated investors and are not available to the general

public. In order to invest in hedge funds, a level of sophistication is necessary to understand

the risks involved as well as the appropriateness of any investment in relation to the

investor’s intentions (Stefanini, 2006).

Furthermore, hedge funds are not liquid investments. Investors are often required to place

their capital in the fund for fixed “lock-up” periods as this gives managers the freedom to

pursue their specific strategies (Crockett, 2007). According to Crockett (2007), investors

often need to provide advanced notice of their plan to sell their holdings and withdrawals

may only take place at specific intervals.

Hedge fund managers charge a management fee and performance fee unlike traditional fund

managers that only charge a management fee (Coggan, 2010). High fees characterise hedge

funds as they employ active strategies that involve highly skilled portfolio managers (Coggan,

2010). Managers who have good track records often charge higher fees, a 2% management

fee and a 20% performance fee is usually charged (Coggan, 2010). A portion of the

manager’s personal assets is invested into the fund in order to align his interests with his

clients.

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1.1.3. The Benefits of Hedge Funds to Investors There are several benefits from investing in hedge funds. According to Visagie (2015), an

advantage of hedge funds is the low correlation with traditional asset classes such as stocks

and bonds, which is therefore beneficial for an overall portfolio due to their positive

diversification effect. The main reasons as to why investors allocate to hedge funds include

returns that are not correlated to equity markets and overall market swings, to reduce

volatility within a portfolio and to mitigate risks in other areas of their portfolio (Lo, 2008).

This has been achieved by maintaining both long and short positions in securities. If hedge

funds are selected carefully, they provide an alternative investment exposure with better

returns and diversification over the long run. Hedge funds are able to reduce market risk as

they provide downside protection during bear markets and upside protection during bull

markets (AIMA, 2007).

1.2. The Evolution of Hedge Funds

1.2.1. Origin of Hedge Funds A.W. Jones set up the first hedge fund in the United States (US) in 1949 (AIMA, 2009). He

started an investment partnership and used his own money as well as other investors’ funds to

make investments (Fung & Hsieh, 1999). He combined two investment tools in order to

attain an absolute return and to hedge against market fluctuations and minimize his risk

exposure. According to Fung and Hsieh (1999), Jones used a market-neutral strategy of

having long and short positions that were equal. He used the money that was made available

from short selling as leverage in order to make further investments and generate more returns

(Fung & Hsieh, 1999).

1.2.2. Global Hedge Fund Growth The global hedge fund industry stayed fairly small until the 1990s when dynamic growth was

experienced. However this growth generally remained in the preserve of private banks and

their clients (Lack, 2012). The number of hedge funds increased greatly in the 1990s as many

were financed by the wealth generated during the stock market rise. According to Crockett

(2007), the near-collapse of the giant Long Term Capital Management (LTCM) fund in 1998

was a big setback for the industry as it helped form the perception that hedge funds are too

risky. Despite this setback, the industry continued to grow and AUM were worth US$237

billion in 2000 (Barclayhedge, 2014). Figure 1 below illustrates the growth of the global

hedge fund assets.

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Figure 1: Growth of Global Hedge Fund Assets (US$ Billions).

 Source: Barclayhedge, 2014.

The global hedge fund industry experienced significant growth from 2002 to 2007. The

global stock markets fell and many pensions experienced large losses and therefore turned to

hedge funds for diversification benefits and better risk-adjusted returns (Lhabitant, 2011).

Some businesses gave finance to new hedge fund managers, known as seeding. This resulted

in a number of new entrants and a large amount of assets from pension funds leading to a

booming industry with assets worth US$2.14 trillion in 2007 (Lack, 2012).

There was a drop in assets after the financial crisis due to significant investor redemptions

and performance based declines (Eurekahedge, 2015).Investors began reducing their holdings

in hedge funds and moved to markets that they were familiar with and assets dropped by 32%

from US$2.14 trillion in 2007 to US$1.46 trillion in 2008 (Figure 1).

Since the crash in 2008, the hedge fund industry has attained new accountability as well as

respectability. As illustrated in Figure 1, the industry has recovered and assets grew to an all

time high in 2014 with an amount of US$2.6 trillion. This significant growth is due to the

funds ability to beat the traditional markets throughout the latest bear periods, as well as from

an increased institutional interest.

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Hedge funds have gradually spread throughout the world. The global industry, mainly North

America, has experienced large growth, as it has been able to attract more investors than

countries such as Europe and South Africa whose investors are cautious about the industry.

Figure 2 presents the global hedge fund map and provides a geographical breakdown of the

global hedge fund industry. An estimated 67% of global AUM reside in North American

hedge funds and there are roughly 11000 funds that are managed by an estimated 6500

managers in the global industry (Eurekahedge, 2015).

Figure 2: Geographical Breakdown of the Global Hedge Fund Industry in 2014.

 Source: Eurekahedge, 2015.

1.2.3. South African Hedge Fund Growth

Hedge funds are relatively new in South Africa and the first fund made an appearance in

1995, 45 years after the first hedge fund was established (AIMA, 2009). Unlike the global

hedge fund industry, South Africa is unique and hedge funds were created with institutions as

the main investors.

The growth in South African AUM was relatively slow until 2003and AUM were worth

around R2 billion (Novare Investments, 2014). Hedge funds were relatively new and were

perceived as being too risky and many domestic institutions and pension funds had been

investing in offshore funds. According to Visagie (2015), different hedge fund structures

have been used among hedge funds such as partnerships and trusts and people are not

familiar with the different structures, which has been an issue for potential investors.

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Institutions have been the main investors in South African hedge funds. Visagie (2015)

suggests that the biggest obstacle to growth on the institutional side was due to the

consultants. Big institutional pension funds would make use of consultants such as Towers

Watson and Alexander Forbes and many consultants refused to recommend hedge funds due

to their belief that these investments were too risky and fees were too high (Visagie, 2015).

This is still a big obstacle to growth in the local industry. However, AUM substantially grew

by 73% from R15 billion in 2006 to R26 billion in 2007 (Novare Investments, 2014). Figure

3 presents the growth in South African hedge fund assets since 2002.

Figure 3: Growth of South African Hedge Fund Assets (R Billions).

Source: Novare Investments, 2014.

AUM dropped by 3% from R30 billion in 2008 to R29 billion in 2009 due to the 2008

financial crisis. However the financial markets in South Africa did not suffer as much as the

global markets, particularly the US, which is illustrated in Figure 1 by the large drop in

global assets during that time. The funds in South Africa had not been exposed to the toxic

assets in the US and had a relatively small amount of foreign investors.

During 2011, Regulation 28 was revised to allow pension funds to invest up to 10% of their

assets in hedge funds (Novare Investments, 2013). It was expected that there would be an

increase in inflows into the local industry. However, it soon became apparent that the pension

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funds that had exposure to hedge funds in actual fact had more exposure to hedge funds than

the revised 10%. Therefore, many pension funds had to cut back on their hedge fund

allocation as some may have had 20% or 25% allocated to hedge funds through bonds or

debenture structures (Visagie, 2015). Although the hedge fund industry’s returns were good,

there was little growth after regulation 28 was revised since there were large outflows (Figure

3).

The South African hedge fund industry reached an all time high during 2014 with assets of

R54 billion, an increase of 29% from R42 billion in 2013 (Figure 3). These assets are

invested in 113 hedge funds that are managed by 55 hedge fund managers, excluding fund of

hedge funds (Novare Investments, 2014). The growth in local assets can be credited to a

combination of solid positive performance from hedge fund managers, particularly equity-

focused hedge funds, in addition to net flows into the industry (Novare Investments, 2014).

The local hedge fund industry is small when compared to the local Collective Investment

Scheme (CIS) industry as well as the global hedge fund industry. The CIS industry had assets

of R1.6 trillion in 2014, whilst the hedge fund industry had assets of R54 billion, thus

representing just over 3% of total CIS assets (Van Niekerk, 2014). The South African hedge

fund assets represent 2% of the total South African pension fund assets, which was worth an

estimated R2.69 trillion1 ($234 billion) in 2014 (Towers Watson, 2015: 6). The global hedge

fund industry had $2.6 trillion in assets in 2014, representing 7.2% of the total global pension

fund assets, which was worth $36 trillion (Towers Watson, 2015: 6). Therefore South African

hedge fund assets as a percentage of total assets are relatively small when compared to the

global industry. The two pie charts in Figure 4 and Figure 5 below are constructed using data

from Towers Watson (2015) and illustrate hedge fund assets as a percentage of total pension

assets. The local industry should be at least three times the size in order to resemble the

industry globally.

                                                                                                               1  Converting  US$  to  ZAR  based  on  an  exchange  rate  of  US$1  to  R11,5  (Rate  for  the  end  of  2014).  

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Figure 4: Global hedge fund assets as a

percentage of total pension fund assets in

2014.

Figure 5: South African hedge fund assets

as a percentage of South African pension

fund assets in 2014.

1.2.4. Evolution of the Investor Base The global hedge fund industry began with high net worth individuals and family offices as

the main investors. They turned to hedge funds as they produced reasonable returns whilst

protecting capital. There has been an increased allocation to hedge funds by institutional

investors since 2000 due to their low correlation with traditional portfolios (AIMA, 2007).

Hedge funds have gradually become open to more private and institutional investors that are

looking for further diversification, higher returns and lower risks (Lhabitant, 2011). These

institutional investors include corporate and public pension funds and endowments. Since the

financial crises, high net worth individuals and family offices have decreased in importance

and the main allocators to hedge funds have been institutional investors (AIMA, 2007). Large

institutional investors have allocated growing volumes of capital to strategies that are

intended to protect capital and provide uncorrelated returns in a world that is changeable

(Hubner, 2014). Institutional investors have started allocating capital directly to hedge funds

and have stopped allocating to funds of hedge funds as it adds on an extra layer of fees

(AIMA, 2007). Figure 6 presents a breakdown of the global hedge fund investors in 2014 and

has been constructed using data from Deloitte research (Faille, 2014).

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Figure 6: Breakdown of Global Hedge Fund Investors in 2014

The South African industry has developed contrary to the global norm, with the industry

being created with institutions as the main investors. According to Visagie (2015), high net

worth individuals are willing to pledge capital reasonably quickly, and with a lot less due

diligence and regulation when compared to institutional investors governed by strict

mandates. A further factor that has stimulated growth in the offshore industry, particularly in

the US, are the large endowments (Figure 6). According to Visagie (2015), endowments have

a very progressive investment approach and have always been proactive in hedge funds and

there are few endowments in South Africa, which has therefore played a role in limiting

growth.

The largest allocators of capital to the South African industry are funds of funds (Novare

Investments, 2014). The demand for South African hedge funds mainly came from pension

funds through funds of funds. According to Agarwal (2009), funds of hedge funds invest in a

portfolio of hedge funds in order to reduce idiosyncratic risk, which is risk specific to an

individual fund. The fund of fund’s skill and expertise is greatly relied on by the end

investors as these investors do not have the ability to select the hedge fund managers that are

best suited to them (Agarwal, 2009). Most investments made into the single strategy funds

are done through the fund of funds. However, their share has been decreasing over the years

and was 61.8% in 2014 as illustrated in Figure 7 below (Novare Investments, 2014).

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Figure 7: Breakdown of South African Hedge Fund Investors in 2014.

Source: Novare Investments, 2014.

According to Carins (2014), the local hedge fund industry is greatly misunderstood and the

perception of local hedge funds has largely been based on the events that occurred globally,

which has held back the industry. A few of these international events include the collapse of

LTCM in 1998, Amaranth Advisors in 2006 and the Madoff Ponzi scheme in 2008 (AIMA,

2007). According to Visagie (2015), the conservative nature of South African investors has

played a significant role in limiting the size of the hedge fund industry. South Africans are

traditionally conservative with the capital and hedge funds have been portrayed as being too

risky, particularly to unsophisticated investors.

1.2.5. Evolution of the Strategies The hedge fund industry was largely based in the US before the 1990s and most managers

specialised in a single strategy, the equity long/short strategy (AIMA, 2014). This strategy

involves buying some stocks that managers believe will rise in price and then shorting others

that the manager believes will fall in price. These funds attempt to hedge the market risk of

their long positions by having substantial short positions or employing derivatives (AIMA,

2007). However, the global industry today is more diverse and there are at least 20 different

investment strategies that investors can choose from. Most hedge funds use equity long/short,

event driven, discretionary macro or multi-strategies in the global industry. Figure 8

illustrates the main strategies used in the global industry.

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Figure 8: Breakdown of Global Hedge Fund Strategies in 2014.

Source: Eurekahedge, 2014: 21.

Although South African hedge fund managers use a variety of different strategies, the

number of strategies used in the global arena is much larger. The main strategies used in

South Africa include equity long/short, equity market neutral, fixed income arbitrage and

multi-strategy (Novare Investments, 2014). The largest group of hedge funds are categorised

as equity long/short, representing 60% of hedge fund assets as illustrated in Figure 9 below

which provides a breakdown of the strategies. Most managers that have come from a long-

only background usually implement this strategy due to their ability to pick stocks (Coggan,

2010). The strategy is close to traditional active management and investors are therefore

familiar with it and attracted to it.

Figure 9: Breakdown of South African Hedge Fund Strategies in 2014.

Source: Novare Investments, 2014.

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Chapter Two -Data and Methodology A qualitative and quantitative approach is used in order to evaluate the South African hedge

fund industry. A qualitative analysis is done in order to evaluate whether high fees have

limited the size of the industry and whether it is due to the regulatory framework that

characterises the industry. A quantitative approach is used in order to evaluate and analyse

the performance of the South African hedge funds and whether this has limited the size of the

industry.

2.1. Performance of Hedge Funds In order to do the analysis, the global hedge fund industry is examined over a period of 18

years, commencing in January 1997, to illustrate the performance over the long run. As the

South African hedge fund industry is relatively new with limited long run data, this study

compares results obtained for the global and local industry over a shorter period of eight

years starting from January 2007. Different types of market environments are covered during

this eight-year time period. The peak of the bull market occurred in early 2008 followed by

one of the worst market stresses in 2008 until 2009, which was characterised by high

volatility and dispersion. The recovery period began in mid 2009 with high volatility initially

which subsided late 2009 and into 2010 (AIMA, 2014).

The overall direction of travel of the hedge fund industry can be measured using an

aggregated hedge fund index and this is a useful measure of the performance of the industry

as a whole (AIMA, 2014). An aggregated hedge fund index and an index for the equity

long/short strategy are analysed in this paper, due to the fact that the main hedge fund

strategy in South Africa is equity long/short. These performance numbers are net of all fees.

Data for the global hedge fund industry were sourced online from the EDHEC-Risk

Alternative Indexes and the Bloomberg database. Bloomberg is an internationally acclaimed

leader as a source of data in the financial markets (Correia, 2012). An aggregated hedge fund

index, the Credit Suisse Hedge Fund Index, containing the performance of all hedge fund

strategies is used as well as the equity long/short strategy obtained from the EDHEC-Risk

Alternative Indexes. The Credit Suisse Hedge Fund Index is a broad based composite of

hedge fund performance and is “asset weighted” and the influence of each fund is based on

their respective AUM (AIMA, 2014). The performance of the global hedge fund industry is

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measured against traditional benchmarks including a stock index, Morgan Stanley Capital

Index World Total Return Index (MSCI World TR), and a bond index, the J.P. Morgan

Global Aggregate Bond Total Return Index. By incorporating these indices in the data set, it

allows for a comparison between the hedge funds performance and an alternative, more

traditional investment approach (AIMA, 2014).

The data used to measure the South African hedge fund industry were sourced from

HedgeNews Africa, which is a leading database for South African hedge funds. The monthly

returns, net of all fees, for the eight year period were obtained for the HedgeNews Africa

South African Single-Manager Composite in order to analyse the performance of an

aggregate hedge fund index. The monthly returns for the equity long/short strategy were

obtained from HedgeNews Africa Equity Long/Short Composite. The benchmarks used to

analyse the hedge fund industry are sourced from the Bloomberg database and contain the

monthly historic prices of the Johannesburg Stock Exchange (JSE) All Share Index (ALSI)

Total Return, the All Bond Index (ALBI), STeFI (cash) and the Three-month Johannesburg

Interbank Agreed Rate (JIBAR).

Hedge funds are generally unregulated and are not required to disclose information or report

on their performance. This has lead to some funds reporting to particular indexes and not to

others and therefore the indexes can differ greatly. In addition, it has been argued that

successful hedge funds mainly report on their performance and funds that have performed

badly do not always publicise their results. Some hedge funds may stop reporting if they have

recently had poor returns. Therefore there is a survivorship bias and an upward bias in index

returns for hedge funds, making them appear to be superior investments than they really are.

However, this is mainly a problem for global hedge funds as they have several different

indexes that they can report to. Since the hedge fund industry in South Africa is relatively

small, this is not a problem and all hedge funds are transparent and disclose information.

Thus the findings regarding the local industry are generally accurate and reliable and do not

suffer from many biases unlike that of its global peers.

This section will highlight the performance of the global and South African hedge fund

industry in comparison to the more traditional investment vehicles, namely long-only funds.

The performance of hedge funds can vary significantly depending on the risk taken and both

risk and return need to be examined when analysing performance (Correia, 2012). Two

  21  

theoretical models and one metric have been applied in order to evaluate the performance of

the industry and assess the risks and returns of hedge funds to determine whether they have

limited the size and growth of the South African hedge fund industry. These three methods

comprise of the returns, risk-return relationship and the Sharpe ratio. The methodology used

in the following section refers to the data spreadsheets attached (Addendum A) and is used in

order to analyse the performance of hedge funds.  

2.1.1. Hedge Fund Returns

The monthly returns were calculated for all indices using the following formula:

𝑅! =𝑃!!!𝑃!

− 1

(1)

Where Rm is the monthly return, 𝑃!is the monthly opening price and 𝑃!!! is the monthly

closing price.

The monthly returns were then rebased to 100 in 1997 and in 2007 for the global returns and

rebased to 100 in 2007 for the South African returns. These data were then used to construct

three graphs illustrating the monthly returns of all the relevant indices. The statistics are

graphically shown in Figure 10, Figure 11 and Figure 12 and are presented in part three.

2.1.2. Risk-Return Relationship The classical risk-return framework is used as a second model in order to analyse these data.

The risk-return relationship displays the tradeoffs between the risks and returns (Correia,

2012). The annualised returns for the eight and 18 year period were calculated for each asset

using the following calculation:

𝐴𝑅 = {(𝑃𝑅𝑂𝐷𝑈𝐶𝑇 𝑅! + 1!"!!!}

(2)

Where AR is the annualised return, Rm is the sum of the monthly returns and m is the

number of months used in that period.

The formula made the two periods into an array in order to allow an analysis of the returns at

the end of the periods if an investor had invested at the beginning. There are 96 months in the

eight-year period and 216 months in the 18-year period which are substituted into the

equation. The annualised standard deviation was then calculated for both periods in order to

analyse the asset’s volatility and risk. The standard deviation is a key metric for investors

  22  

looking for steadier returns (AIMA, 2014). The annualised standard deviation was calculated

using the following formula:

𝜎 = 𝑆𝑇𝐷𝐸𝑉 𝑅! ∗ 𝑆𝑄𝑅𝑇(12)

(3)

Where 𝜎 is the annualised volatility and Rm is the sum of the monthly returns for the period.

The annualised returns and standard deviations were then used to construct three graphs in

order to illustrate the risk and return relationship of the different investments. Figures 13, 14

and 15 in the next section graphically illustrate the annual risk and returns for the global and

local industry for their relevant time periods.

2.1.3. The Sharpe Ratio The third method used to analyse these data is the Sharpe ratio. A common cited statistic in

financial analysis is the Sharpe ratio which is the risk-adjusted performance metric of choice

amongst most hedge funds and it is a measure of excess return to risk (Lhabitant, 2004). The

Sharpe ratio measures the risk-adjusted returns and is important when measuring the

performance of the global and local industry. It is used in order to understand how much risk

was undertaken in order to generate the alpha (the returns) (AIMA, 2009). Investors would

often rather have returns that are steadier with lower volatility rather than higher returns that

have higher volatility. The higher the Sharpe ratio, the better the return per unit of risk taken

(Correia, 2012). The Sharpe ratio is calculated using the following formula (Correia, 2012):

𝑆𝑅 = (𝑅 − 𝑅𝑓𝜎!

)

(4)

Where SR is the Sharpe ratio, R is the annualised return, Rf is the annualised risk free rate

and σr is the annualised volatility of the fund (Standard deviation).

The US 3Month Treasury Bill (T-Bill) rates and the 3Month JIBAR were obtained and the

average was calculated for the period in order to calculate the Sharpe ratio. The relevant

Sharpe ratios are calculated and the summary statistics are presented in Table 1 and Table 2

in part three to illustrate the risk-adjusted returns.

2.2. Hedge Fund Fees and Regulations In order to analyse the fees of hedge funds and the regulatory framework that characterises it,

various sources were collected and examined. The methodology involved gathering primary

  23  

data for this study through three interviews with professionals in the local hedge fund

industry in order to gain insight into South African hedge funds. Robert Oellerman was

interviewed who is a cofounder of Tantalum Capital. The second interview was conducted

with Eugene Visagie from Novare Investments. Lastly, Kevin Shein was interviewed who

works at Laurium Capital. The insights and data sourced from these interviews assisted in

analysing the fees that characterise hedge funds, their performance and the regulatory

framework that characterises the South African Industry.

Secondary data were collected from various sources including academic journals, surveys,

books, articles and the Internet in order to gain wide-ranging information on the industry.

Data were sourced from Novare in order to do an analysis on the South African hedge fund

industry. Novare Investments provide an annual survey where they report on hedge fund

performance for the local industry and data for the growth of local assets were obtained from

this source. The data collected from all three respondents and several secondary sources was

analysed and important aspects concerning the South African hedge fund industry were

assessed in order to reach a conclusion about the limited size of the local industry.

  24  

Chapter Three - Data Analysis and Results

3.1. Hedge Fund Performance

3.1.1. Returns Analysis

As illustrated in Figure 10 and Figure 11 below, equities fell much further than hedge funds

and bonds in 2008 on an absolute return basis. The maximum drawdown (largest peak-to-

trough loss over a period) for equity was large and occurred between September 2007 and

February 2009. Bonds have traditionally done better than equities during turbulent times and

bonds have done better over the last few years, as yields have been high. It is evident from

Figure 11 that bonds outperformed the other asset classes over the last eight years. The

long/short equity index performed well and has provided high returns, net of all fees. Both

hedge fund indexes outperformed the other assets in the long run with less volatility.

Figure 10: The Returns of Global Assets from 1997 to 2014.

 

 

  25  

Figure 11: The Returns of Global Assets from 2007 to 2014.

Hedge funds were not designed to outperform bullish equity markets, but rather protect

capital and provide an alternative return to an investor’s portfolio (Hubner, 2014). South

African hedge funds have managed to do just that as illustrated by the returns of the hedge

fund index in Figure 12 below. Hedge funds have performed relatively well since 2007 and

the local hedge fund industry has managed to capture a large proportion of the equity bull

market performance with a significantly lower amount of risk, as illustrated in Figure 12.

Over the past eight years, South African hedge funds have been able to capture a large share

of the equity market performance as measured by the JSE ALSI. Hedge funds have

outperformed South African bonds as measured by the ALBI. Hedge funds did not suffer

from high volatility to the same extent as equities did during 2007 and 2008 and were able to

recover quickly in 2009 (Figure 12). The returns of hedge funds have been significantly less

volatile than the returns of equities, particularly during the declining market conditions.

These data clearly illustrates that hedge funds in South Africa are doing what they are

intended to do which involves protecting capital during bear markets whilst capturing some

of the upside during bull markets (Hubner, 2014).

  26  

Figure 12: The Returns of South African Assets from 2007 to 2014.

 

3.1.2. Risk-Return Analysis Hedge funds have done significantly better in the long run. The annualised returns were much

higher for the aggregate hedge fund index over the 18-year period with annualised returns

around 8.3% compared to those of equity and bonds that were around 5.5% (Figure 13). The

returns over the shorter period have been similar for all global indices with the average eight

year returns around 4.5% (Figure 14). Thus global hedge funds have done well in comparison

to global equities and bonds, particularly in the long run.

  27  

Figure 13: Global 18-year Annual Risk-Returns (1997-2014).

 

 

Figure 14: Global eight-year Annual Risk-Returns (2007-2014).

  28  

South African hedge funds have done significantly better than equities and bonds when

analysing both risk and returns. Figure 15 shows that hedge funds have outperformed both

equities and bonds on a risk-adjusted basis, despite the size of the equity bull market after the

financial crisis. Although Figure 15 illustrates the slightly higher annualised return for the

JSE ALSI index, it has had more than double the amount of risk than local hedge funds and

equity long/short. Both the local hedge fund index and equity long/short index have exhibited

lower volatility of returns than both equities and bonds whilst still providing sufficient returns

(Figure 15).

Figure 15: Annualised risk and returns for the South African industry from 2007 to 2014.

 

3.1.3. Sharpe Ratio Analysis As illustrated in Table 1 below, both hedge funds as a whole and funds operating as equity

long/short performed better over the long term. They both had higher annualised returns in

the long term with similar annualised volatility and their Sharpe ratios were therefore

significantly higher. Both hedge fund indices did significantly better than the MSCI World

index in both periods. Both indices only outperformed bonds in the longer period as bond

yields have been high since the crisis and have recently performed better. The low returns for

  29  

the bear period pulled the Sharpe ratios down significantly for equities and hedge funds. The

MSCI World was characterised by high volatility, which resulted in the low risk-adjusted

returns and a Sharpe ratio of 0.22. Therefore hedge funds offer better risk-adjusted returns

than alternative investments and perform well over a longer period.

Table illustrating the eight-year and 18-year annualised Sharpe Ratios for the global

industry.

Annualised eight-year period Annualised 18-year period

Index Annual

Return

(%)

Annualised

Volatility

(%)

Sharpe

Ratio

Annual

Return

(%)

Annualised

Volatility

(%)

Sharpe

Ratio

Credit Suisse

HFI

4.64 6.18 0.63 7.85 6.81 0.82

Long/Short

Equity

4.60 7.46 0.52 8.54 7.30 0.86

MSCI World

TR

4.05 15.25 0.22 5.95 14.72 0.25

J.P. Morgan

Global Bonds

4.59 5.98 0.65 5.21 5.85 0.50

Table 1. Annualised Sharpe Ratios for the Global Industry.

Table 2 is shown below and indicates that over the last eight years, hedge funds have

dominated other investment categories and have managed to outperform the key standalone

asset classes based on risk-adjusted returns. The Sharpe ratios for the aggregate hedge fund

index, 2.16, and long/short equity, 0.77, are greater than they are for equities and bonds

(Table 1). The Sharpe ratio for the ALSI is only 0.31 which is less than half of the equity

long/short ratio. Although equities offer slightly higher returns than hedge funds, they also

offer higher volatility as seen in Table 2 and Figure 15. This illustrates that hedge funds have

been able to attain substantial returns with a lower level of risk and a lower standard

deviation of returns.

  30  

Table illustrating the eight-year annualised Sharpe Ratios for the South African

Industry.

Annualised eight-year period

Index Annualised

Return (%)

Annualised

Volatility (%)

Sharpe Ratio

HNA SA Single-

manager composite

10.90 1.74 2.16

Long/Short Equity 11.44 5.43 0.77

JSE All Share Index

(ALSI) TR

12.23 15.94 0.31

All Bond Index (ALBI) 8.65 7.08 0.19

Table 2. Annualised Sharpe Ratios for the South African Industry.

3.2. Hedge Fund Fees Hedge fund managers are compensated in two ways. They charge a management fee as well

as a performance fee. The fee structure amongst hedge funds vary but the standard model in

the global industry is generally “2 and 20” (Coggan, 2010). Thus they charge a 2% annual

management fee combined with a 20% performance fee on profits. A hurdle rate is used for

calculating performance fees and the manager of the hedge fund needs to perform above the

high water mark (Connor & Woo, 2004). Investors are protected to an extent by a high water

mark system as this system allows performance fees to only be charged if the fund previously

reached its peak (Coggan, 2010). A hurdle rate is used for most hedge funds and the fee is

only paid on the performance of the fund in excess of a particular benchmark. The

performance-based incentive fee is a significant feature for the hedge fund’s success (Connor

& Woo, 2004). High fees characterise hedge funds due to the fact that these funds employ

active strategies that involve portfolio managers that are highly skilled. Hedge funds have

minimum investment levels that are usually high. These high minimum investment levels

limit the number of investors (Connor & Woo, 2004).

Whilst hedge funds are often referred to as expensive, the average fee charged by South

African hedge funds is less than the typical “2 and 20” fee charged globally. The average

annual management fee charged by South African hedge funds was 1.2% in June 2014, a

  31  

slight increase from 1.1% as at June 2013 (Novare Investments, 2014). Around 64% of hedge

funds charged an annual management fee of 1% per annum in 2014 (Novare Investments,

2014). The majority of hedge funds in South Africa charged a performance fee of 20% in

2014 with 87.3% of assets illustrating this (Novare Investments, 2014). The South African

cash rate (measured by the STeFI Composite) is generally used as the hurdle rate to

outperform before a fee for performance is taken, indicated by 76.8% of industry assets

(Novare Investments, 2014). Although high fees characterise the hedge fund industry, the

fees are lower in South Africa than they are offshore. However, fees are significantly higher

for the local hedge fund industry than they are for long only funds (Visagie, 2015; Shein,

2015). Therefore many investors have stayed away from hedge funds in South Africa due to

the high fees when compared to long only funds, which average around 0.7% including

performance fees (Shein, 2015). According to all three interviewees, high fees have definitely

contributed to limiting the industry’s growth.

A few pension fund industry consultants have been very pro hedge funds whilst many have

not due to the high fees and these consultants have limited the growth of the local industry.

Although high fees characterise the hedge fund industry in South Africa, they are not as high

as their global peers. In addition, in South Africa the average manager’s performance, which

is always shown net of fees, has more than compensated for the high fees.

3.3. Hedge Fund Regulations

3.3.1. Global Regulations Global hedge funds have been operating in a space that is unregulated at both manager and

product level. They are considered to be risky as well as complex investment vehicles that are

only available to institutional investors and wealthy individuals.

The American regulatory system on hedge funds has been extremely light until recently.

Hedge funds were not required to register in their role as advisors for a long time. The lack of

regulations allowed the industry to construct super-sized structures that were opaque and a

platform was formed for some managers to defraud the system. The growth in global hedge

funds has been accompanied by several fraud enforcement cases due to the lack of regulation

(Coggan, 2010). The financial failures and scandals led to the perception that hedge fund

products are extremely risky.

  32  

The most common form of hedge fund regulations relates to restrictions on financial advisors

and managers in order to minimise fraud. Hedge funds fall outside the jurisdiction of the

regulators in the US and are free from various reporting and registration requirements since

they do not deal with the public but rather deal with sophisticated investors. The Securities

and Exchange Commission (SEC) in the US requires hedge fund investors to be accredited

(AIMA, 2014). They must thus earn a minimum amount of money annually and have a large

amount of investment knowledge.

The financial crises led to a new outlook on regulations for hedge funds. The US and Europe

had regulations passed in 2010 in order to increase government oversight and make hedge

funds more transparent by increasing the reporting requirements and disclosures from

managers. These legislative changes include the US’s Dodd-Frank Act and European’s

Alternative Investment Fund Managers Directive (AIMA, 2014). As a result transparency has

increased as hedge funds have delivered more information to investors including information

on valuation methodologies, positions and leverage exposure.

3.3.2. South African Regulations The South African hedge fund industry is unique and characterised by a high degree of self-

regulation. The local industry has been able to learn from the mistakes of the global industry

due to it being a young industry. The local industry has therefore been characterised by a high

degree of self-regulation before the more formal regulations were introduced (AIMA, 2009).

The local hedge fund products, until recently, were not directly regulated under law.

However indirect regulation has resulted in only an elite group of knowledgeable investors

being able to access the hedge fund industry. This has led to the limited size of the hedge

fund industry in South Africa compared to its global peers.

The South African asset management industry has had regulations in place for several years

that govern the conduct of financial service providers. In order to run a fund or manage

money a manager is required to register with the Financial Services Board (FSB) for a

Category 2 license (National Treasury, 2014). This license is stringent and a manager is

unable to start a business without it. Unlike the rest of the world, hedge funds in South Africa

have always been regulated at the manager level under the Financial Advisory and

Intermediary Services Act, No. 37 of 2002 (“the FAIS Act”) (National Treasury, 2014).

Regulation at manager level generally means that all managers are required to register with

  33  

the FSB to verify that they are fit and proper. In 2007 a special condition, Category 2A, was

implemented specifically for hedge fund managers and the requirements are more stringent

than those of Category 2 (Novare Investments, 2013). Besides needing all the necessary

requirements for a category 2 license, hedge fund managers need to meet additional

requirements to obtain a category 2A license. Visagie (2015) mentioned that one of the main

obstacles to obtaining a category 2A license is the need to have an additional three million

rand in liquid capital as not many South Africans have this extra cash. Therefore the

additional requirements under Category 2A have limited the growth of the industry.

Further progress on the regulatory front in South Africa was the revision of Regulation 28 of

the Pension Funds Act in 2011 (Novare Investments, 2013). The revision made an explicit

allowance for hedge funds to be included in the asset allocations of pension funds. Pension

funds may now invest 10% of their portfolios in hedge funds, which was raised from 2.5%

(National Treasury, 2014). The industry expected to see an increase in demand and

allocations from pension funds as well as significant inflows. However both Oellerman

(2015) and Visagie (2015) stated that the industry actually saw outflows from hedge funds

following the revision.

The National Treasury and the FSB proposed a solution for the hedge fund industry in South

Africa in February 2015 to regulate the hedge fund product that is expected to provide an

industry that is more transparent through regulation (Shein, 2015). This development is due

to the recent change to the Collective Investment Scheme Control Act (CISCA), which

governs long-only funds (National Treasury, 2014). This new legislation has been passed in

South Africa to initially deal with systemic risk that the hedge funds are perceived to pose to

the financial system and furthermore to allow the South African public to make use of

regulated hedge fund type products.

The new regulations have resulted in two distinct hedge fund categories: a Retail Investor

Hedge Fund (RIHF) and a Qualified Investor Hedge Fund (QIHF) (National Treasury, 2014).

The RIHFs will be freely available to the general public. There will be more stringent

prudential and risk management requirements and rigorous regulation for these funds in order

to attain sufficient protection for investors given their retail focus. These funds will be tightly

regulated and their risk appetite will be limited in order to protect investors (Novare

Investments, 2013).

  34  

In contrast, the QIHFs will be subject to limited access by sophisticated investors such as

pension funds, asset managers and insurance companies. The Minister of Finance declared

that all current hedge funds would fall under CISCA and become QIHFs and continues to

operate in a similar way as to how they have always operated (Shein, 2015). These funds will

not be rigorously regulated and the regulations will mainly be an improved focus on risk

management as well as to assist reporting and transparency to the regulator and investor

(National Treasury, 2014). This will therefore assist with improved monitoring of systemic

risk and lead to more protection through increased requirements for disclosure.

Visagie (2015) believes the new regulations will benefit the local industry by attracting many

new investors. Confidence will be increased as can go to the investors and say that this is

now a unit trust and many people are familiar with unit trusts and confident in them and their

structures. Although the regulations have been introduced, the products are still not regulated

and are likely to only be so in 2016.

The institutionalisation of the local hedge fund industry resulted in enhanced governance and

accountability and created a more open and transparent industry unlike that of its global peers.

Local hedge funds have always been transparent with regard to disclosing their portfolio

holdings and daily viewing is permitted by 60% of contributing assets (Novare Investments,

2014).

According to Visagie (2015), education is very important and investors need to be educated

about hedge funds and how they work in order to grow the industry. The industry needs to

change the perception of hedge funds and illustrate how they do not use excessive leverage

and that they are not too expensive. Investors need to be shown that they can actually reduce

risks without reducing returns by including hedge funds in their total portfolio. In addition,

the new regulations will attract more investors as the asset class will be open to more retail

investors and the minimum level for investment is expected to drop (National Treasury,

2014). It is likely that there will be an increase in demand and most long-term investment

portfolios will begin to include hedge fund strategies.

  35  

3.4. Results

3.4.1. Qualitative Factors – Nature and Sophistication of Investors The nature of South African investors appears to have played a meaningful role in limiting

the size of the hedge fund industry. South Africans are very conservative and suspicious of

hedge funds despite their high absolute and risk adjusted returns. They perceive hedge funds

to be high risk, expensive and complex with little transparency. As a result, pension fund

trustees and consultants have generally avoided hedge funds. However the analysis shows

that the local industry differs significantly to that of its global peers by being better regulated,

far less volatile, having lower fees and less leverage. Furthermore, local hedge funds have

been much more conservatively managed than their global peers, with much more

transparency.

The investor base in South Africa has played a big role in limiting the growth of the industry.

Endowments, particularly in the USA, have a very progressive investment approach and have

always been proactive in hedge funds, which has been illustrated with funds offshore. There

are few endowments in South Africa, which has therefore played a role in limiting growth.

3.4.2. Quantitative Factors – Hedge Fund Returns Global and local hedge funds have proven to be less volatile and risky when compared to

equities (JSE ALSI and MSCI World). They have achieved higher Sharpe ratios, which

illustrate their ability to provide sufficient returns with lower risk. South Africa hedge funds

have performed well on an absolute returns basis after fees. They have also done very well on

a risk-adjusted basis and have outperformed both equities and bonds locally. They have

managed to provide high returns with a third of the risk of South African equities. South

African hedge funds are much more conservative than their global peers and they have not

used excessive leverage or been characterised by as high volatility and risk. The returns of

hedge funds have thus not impacted the growth of the local industry and are not a reason for

the limited size.

3.4.3. Combined Factors – Fees and Regulations

High fees have played a big role in limiting the growth of the South African hedge fund

industry. Both management and performance fees are lower on average in South Africa than

they are offshore, however, fees are significantly higher for the local hedge fund industry

than they are for long only funds, which has led to many institutional investors not investing

  36  

in hedge funds. South African institutional investors are suspicious of the fees, even though

they are tied to performance and as a result have stayed away from investing in hedge funds.

The asset management industry has transformed due to increased regulation. There has been

a substantial increase in the focus on compliance monitoring as well as implementation of

processes in order to assist regulatory reporting. The South African industry through the FSB

has regulated hedge fund managers and there has been a lot of self-regulation, well ahead of

the global industry. Pension funds in South Africa and consultants tend to be very

conservative and have stayed away from hedge funds as the product has not been regulated

under law. The local hedge fund industry is relatively small and one of the reasons may be a

result of it falling out of the regulatory framework. However the changes in regulation to

regulate the hedge fund products under CISCA should see strong growth in hedge fund assets

going forward as they attract investments away from the more conservative and regulated

long only sectors.

The lack of hedge fund product regulation, together with high minimum investment levels

into hedge funds of around R1 million has resulted in a limited investor base. The new

regulations should lead to an increase in investors as the minimum level of investment is

expected to drop to around R50 000 which will attract more retail investors. While

historically the limited regulatory framework has played a role in limiting the growth of the

local hedge fund industry the new changes to regulation are expected to make hedge funds

more mainstream and increase the demand for hedge funds.

  37  

Chapter Four - Conclusion The above analysis has illustrated the benefits and potential risks of investing in hedge funds

as well as highlighting how they can be used to enhance diversification, reduce volatility and

improve risk-adjusted returns. South African hedge funds have generated superior absolute

and risk-adjusted returns net of fees. Hedge funds as an asset class have been able to deliver

healthy returns during almost all market environments and are excellent diversifiers to most

portfolios. However the size of the South African hedge fund industry has been limited due to

regulations, high fees, the investor base and the conservative nature of South Africans. The

analysis also examines a great deal of qualitative factors that have led to hedge funds in

South Africa perhaps not gaining as much traction as would be expected in a market that seek

efficient allocation of capital.

The nature of South African investors has played a meaningful role in limiting the size of the

hedge fund industry. South Africans are very conservative and suspicious of hedge funds

despite their high absolute and risk-adjusted returns. Hedge funds are perceived as being high

risk, expensive and complex with little transparency. As a result, pension fund trustees and

consultants have generally avoided hedge funds. However this paper clarifies that the

local industry significantly differs to that of its global peers by being better regulated, far less

volatile, having lower fees and less leverage. Furthermore, local hedge funds have been much

more conservatively managed than their global peers, with greater transparency.

South African hedge funds have consistently outperformed local equities and bonds on a risk-

adjusted basis and their performance has not been a contributing factor to the limited size of

the industry. The performance of South African hedge funds, net of fees, has in fact been

superior to most other asset classes both globally and locally. The South African hedge fund

industry performed better than its international peers and consistently outperformed equities

and bonds on a risk-adjusted basis, a measure that is highly valued by investors. They have

managed to provide high returns with a third of the risk of South African equities and

achieved a higher Sharpe ratio, which is an important factor when deciding on an investment.

High fees characterise the hedge fund industry both globally and in South Africa. Both

management and performance fees are lower on average in South Africa than they are

offshore. However, fees are significantly higher for the local hedge funds than they are for

  38  

long only funds, which has led to many institutional investors not investing in hedge funds.

Despite strong performance net of fees, asset consultants in South Africa have been reluctant

to recommend hedge funds due to the high absolute level of fees, which has greatly limited

the industry.

The hedge fund industry in South Africa is unique as regulations have been much stricter

than those applicable to the global industry. In South Africa hedge fund managers are

regulated by the FSB. However, until the recent 2015 changes in regulations hedge fund

products in South Africa were not regulated. Historically most Pension fund consultants, who

tend to be very conservative, have avoided hedge funds as the product has not been regulated

under law. In addition the general public has not been familiar with South African hedge

funds mainly due to all hedge fund products falling outside of the regulatory framework.

The new regulation that has been passed in South Africa will benefit local hedge funds as

they are likely to become more mainstream due to the industry being fully regulated. With

hedge fund products set to be regulated under CISCA, strong growth appears likely over the

next few years due to the interest from retail investors who want to include hedge fund

strategies in their portfolios. A further benefit of the new regulations in South Africa will be

the promotion of integrity as well as greater transparency.

To answer the question initially posed, succinctly, the size of the South African hedge fund

industry has been limited due to: regulations disallowing meaningful investment from

institutional investors; a conservative investor culture; and the notion that hedge funds are

expensive. Given the largely qualitative reasons for not investing in hedge funds, the risk-

adjusted returns suggest hedge funds should be a meaningful, if not vital, part of a balanced

portfolio.

Considerations for future research should be aimed at analysing the South African hedge fund

industry over a longer period. The credibility of the results would be improved by using a

larger sample size and a longer testing period to check whether the good short-term hedge

funds returns would have continued over the long run. Furthermore, it would be beneficial to

look at the affects of the new regulations and determine whether they do contribute to growth

in the future.

  39  

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Addendum