The challenges facing the South African Hedge Fund Industry

As the South African hedge fund industry moves from its infancy stage, numerous challenges are being faced that will determine the ultimate long term success of the industry.

Perhaps the most crucial of all challenges to be addressed is that of the integrity of the industry. During the early years, most industry players understood the need to work together in order to ensure that the result was a self-regulated, high quality industry that could attract asset flows from sophisticated institutional industry.

The entry of new players not part of this early process and increased competition amongst existing participants has seen the emergence of some of the broader financial industry’s scourges such as excessive entertaining of pension fund trustees and consultants, and other kick-backs.

Allocators of capital need to be vigilant in their approach and ensure they are rewarding performance and solid processes rather than short-term, non-investment related, self-benefitting rewards. It is up to industry players to highlight these issues and rid the industry of such practices if we are to build something with the clients’ interests at heart. Industry participants, such as consultants, pension fund trustees, fund of fund managers and hedge fund managers, need to remember that it’s not their money, it’s the clients’.

Another key challenge is ensuring that high investment standards are maintained. This can only be done by ensuring that criteria for entry in terms of talent are kept strict. Given the added tools at a hedge fund manager’s disposal, and the complexity and potential extra risk these tools can subject an investment to, only the very best investment brains should be running money in this fashion. This should help minimise the number of potential blow-ups that the industry may be exposed to in the future. The FSB’s recent decision to necessitate hedge fund managers to fulfil certain requirements in order to qualify for the 2a licence required to run a hedge fund is a step in the right direction. Legislation, though, will always only achieve part of the desired goal. It is crucial that fund of hedge fund managers are vigilant in their approach to new managers and only allocate to the best talent available.

In its early stages, the South African hedge fund industry was dominated by a plethora of long/short equity funds. This has been in keeping with international trends and also helped by the length of the most recent bull market. It is also regarded as the “easiest” strategy to understand and run. While other equity-based strategies, such as market neutral, and fixed income arbitrage have also emerged, the South African market remains focused from a strategy perspective compared to international trends. It is inevitable that new, more complicated strategies seen globally will be tried in the local market. The first of these to emerge has been structured finance funds which have started over the past 24 months. While this will create a wider toolset for investors and hopefully ensure that risk/return expectations are more adequately fulfilled, the complexity of strategies can often lead to added problems. Investors need firstly to ensure they distinguish between strategies that are hedge funds and alternative investments. Internationally, this has been a differentiation that has been allowed to blur, with the consequence that hedge funds have become the catch-all category for investments that don’t fit into other classifications.

Without performance, any investment strategy is effectively worthless. The local hedge fund industry has seen some stellar performances from both single strategy and fund of hedge fund managers. Until 2008, much of this coincided with an equity bull market, which made it difficult for investors to assess whether this performance was sustainable through a bear market. 2008 delivered incredibly difficult conditions and, on the whole, most hedge funds were able to preserve capital and, in some cases, deliver returns well in excess of cash. With 2009 continuing to be trying, the challenge is to continue to negotiate these tricky markets in a manner that fulfils the performance expectations of the clients. At the end of the day, in an industry promising absolute returns, one has to deliver in the tough times to justify one’s existence.

Another challenge facing the hedge fund industry is the clarification of the fee structures. The popular view is that hedge fund managers charge a 2% management fee and a 20% performance fee above a high watermark; however this is not necessarily true. In South Africa, the management fee is often 1% or 1.5% (and even lower for large institutional clients) and the performance fee is generally only charged if the fund manager beats cash, with the performance fee only being charged on the outperformance of that cash benchmark. The return numbers from hedge funds are also reported net of all fees, so an investor gets exactly the return quoted to them. When compared to charges in the unit trust industry, these fees are in fact not out of line. For example, many unit trusts charge performance fees and their management fee often varies between 1% and 1.5%, sometimes higher. This is particularly true when compared with the absolute return sector, the closest style of product accessible to investors under the unit trust banner. But the perception remains that hedge funds are expensive and the challenge to the industry is to both clarify this and prove that whatever fees are being paid is money well spent by the investor in the pursuit of superior returns.

The final major challenge will be for the hedge fund industry to ensure that it has sufficient client diversification. Like any burgeoning industry, the success has been built on a few pioneering clients whose assets make up the bulk of those invested. Broadening this base will be crucial to ensure that when, and if, a large client decides to allocate assets elsewhere, the industry itself is not negatively affected. There are a number of avenues which funds can pursue to achieve this, including obtaining offshore clients. Ensuring broader buy-in from consultants is another key area which could unlock a more diverse client base. This can ultimately only be achieved by the industry having a product which purveys to its clients, and prospective clients, a clear and understandable offering that delivers on its stated goals.

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