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HEDGE FUNDS & ALTERNATIVE INVESTMENTS FEATURE
ANDREW LUDWIG Director, BLACK ONYX
M
31 July 2018
When do you start considering the alternatives?
ost people accept that we’re at the top of a bull market, but what’s fascinating is how quickly you and I have forgotten what happened 10 years ago. I’m not a bear, but right now I’m anxiously bullish and would like to share some thoughts around the establishment of a sophisticated investment portfolio specifically for this cycle of uncertainty, which considers the general equity & balanced funds, passive ETFs, but most importantly the regulated alternatives like hedge funds, which are CIS, Regulation 28 compliant. Right now, there are two investor camps: those that believe the drawdown in February (2018) was the much-anticipated financial correction, and those who believe the worst is yet to come. My leaning is into the latter, who have braced themselves for the next couple of years. But we all hate FOMO, so how do you navigate this period of market uncertainty and how much upside is there really left, and how much risk are we prepared to take in pursuit of the apparent low-hanging fruit? Brexit and then Trump should have been the catalyst to a market correction akin to 2008 but gave rise to a ridiculous upsurge on the S&P and JSE – perhaps the tail-end of quantitative easing (QE) or a result of all the (US) baby boomers pension money sloshing around in the new order of ETFs (an entirely new asset class born out of the underperformance of active managers, and one yet to be tested in a cataclysmic market correction). The signs of change may well be in our face when you consider global debt has once again been dispersed across the economy, much like sub-prime mortgage lending before the global financial crisis. There is the ever-looming threat of the Federal Reserve raising interest rates and that strong US earnings cannot last. China, the second largest economy, may also self-implode under its opaque guise of failing enterprises and bad debts. Let’s face it, we’re all impacted if the US and China sneeze. Closer to home, December 2018’s political get-together was anyone’s guess. Ramaphoria will taper and, consistent with South Africanism, we will enter yet another period of uncertainty (2019 elections); but what are we as investors, advisers, custodians of other persons’ wealth etc. supposed to do? Do we go to cash, do we send even more money offshore, do we do nothing, or do we think about the alternatives and portfolio diversification that ensures uncorrelated returns while minimising the risk? The last 30 years have seen a declining interest rate environment, critical to the seemingly ‘bulletproof ’ multi-asset portfolios (60 equity/40 bonds), and we are actually paying the institutions to borrow our money. More recently, the inverse relationship of bonds and equities has shifted and may actually become the new norm. There are excess leverage and liquidity concerns, and it’s all looking very familiar to some. The rising market has been beta driven, with euphoric consumer sentiment great for passive
strategies, especially during an abnormally low volatility cycle. Sadly, the past decade’s high-double-digit equity returns propped up by cheap-money policies like QE, are likely a thing of the past. The search for alpha becomes increasingly difficult, with an increasing emphasis on fundamentals. If you are at all anxious, now is certainly the time for active management, especially that which demonstrates diversification, reduced correlation and especially low volatility. 2017 was a bumper year for the ALSI, and all thanks to three miners and a luxury goods producer, not forgetting that Naspers accounted for over 25% of the JSE and was up 75% for the year. Remove those five stocks and the index would have been flat, as well as unit trusts, ETFs and most pension funds. Across the pond, four tech stocks and the men of Omaha dominated the S&P 500, but with their exclusion, the US index would have also been flat. That’s awfully concentrated and why so many hedge funds could never keep up because, by design, they are not lemmings, hence we pay them to be contrarian, to actively identify fundamental value, to be the ‘hedge’ of our more mainstream, seeming less risky (pension) investments. So why would you ever consider an alternative strategy like a hedge fund, and what do you know about this seemingly expensive, nefarious, risky beast? Did you ever consider that they are employed alongside your existing traditional strategies to bring down your portfolio’s risk? The benefits of the alternatives are: • Better returns and less risk than the JSE over time • Better returns and less risk than most unit trusts over time • Portfolio diversification that ensures uncorrelated returns • Active fund management that minimises downside risk • Investor protection via FSCA-regulated CIS structures.
And while 2016 and 2017 were shockers for equity long-short hedge funds, other hedge strategies fared well (fixed income especially), but still delivered very low volatility that is key to wealth preservation. The most likely reason for such underperformance was that many hedge fund managers took defensive positions, anticipating a market correction (after eight years), and missed the rally after Trump. As such, many alternative managers were not overly exposed to the aforementioned top performing stocks with the conviction that we were likely at the top of the market and the risk/reward no longer made sense. What about a real benchmark then, back in the days before we ever knew ETFs existed? The year 2008 speaks volumes.
This is not flash-in-the-pan stuff, with hedge funds having been in SA for as long as 18 years. Many hedge fund managers were once the decisionmakers at the largest asset managers and likely played an integral role in your current retirement strategy. They left to establish their own mandate (CIS / Regulation 28), affording them an opportunity to chase true alpha, diversification, low volatility and ensure the least correlation to your existing nest egg. There are over 300 regulated CIS hedge funds available in SA, many of which are Regulation 28. To conclude, hedge funds will likely underperform general equity funds and balanced funds in today’s rising market (typically designed to capture 80% of the upside) and then hopefully earn their keep in the bearish, volatile cycles by minimising the downside risks. A collaboration to establish a sophisticated Regulation 28 investment portfolio, which considers ETFs, general equity funds and balanced funds, including the alternatives to establish better risk-adjusted returns, makes complete sense in creating a sophisticated Regulation 28 investment portfolio – all other things remaining constant. A sophisticated portfolio should include 10-30% in the alternatives, a prudent allocation when 53% of US university endowment allocations are into alternative strategies. The author is an alternative investment consultant at BLACK ONYX, invested in all the aforementioned strategies.