Hedge funds and their benefits

By PABALLO NHAMBIRI Quantitative Analyst, Terebinth Capital

and DUMISANI NGWENZA, Quantitative Analyst, Terebinth Capital

Hedge funds play an important role in the financial system. They are a significant source of liquidity that help improve market efficiency and price discovery and, most importantly, contribute to absorbing financial risk. As an asset class, hedge funds offer investors the potential to generate absolute riskadjusted returns that are not correlated to the market. They are also one of the most efficient ways by which investors can access skilled managers, diversify risk, and gain exposure to a wide variety of investment opportunities.

Despite their positive attributes, there is no formal or universally accepted definition of hedge funds. Still, we can describe them as actively managed portfolios that generate returns by employing a wide range of strategies, which include the application of leverage, long and short strategies, and the use of derivative instruments to enhance returns and/or protect investors against downside risk.

Historically, the first modern hedge fund was established in the United States in the 1950s with funds that were initially structured as limited partnerships. They were not required to register themselves as investment advisers with the Securities Exchange Commission (SEC). This meant they could not raise capital through advertisement to the public and, therefore, were only reserved for institutional and accredited investors. The JOBS Act, signed into law by President Barak Obama in 2012, provided an amendment to these rules, which were subject to adequate disclosures and disclaimers being made to potential investors.

Introduction under CIS umbrella

Locally, prior to April 2015, South African hedge funds were available only to accredited investors able to invest a minimum of R1m. On 1 April 2015, hedge funds in South Africa were declared Collective Investment Schemes (CIS), in accordance with the Collective Investment Schemes Control Act 2002 (CISCA) – moving from a less regulated to a strictly regulated environment, with objectives of enhancing investor protection, promoting transparency and market integrity and, most importantly, preventing systemic risk. The regulation provided for two types of hedge fund categories: Qualified investor hedge funds (QIHFs) restricted to accredited investors with a minimum investment of R1m; and retail investor hedge funds (RIHF) open to ordinary investors.

A firm’s risk management framework should aim to highlight the risks that are associated with its chosen strategies

In summary, there are three benefits to hedge funds’ inclusion into CIS portfolios:

• They can now target a larger audience and attract large sums of capital

• Their managers are required to meet ‘fit and proper’ requirements and to obtain licensing and registration

• They operate in a stricter regulated environment, which further enforces a requirement for managers to establish robust risk management controls that are suitable for the investment strategies they employ, the size of their portfolios, and the investment processes they have adopted.

Therefore, a firm’s risk management framework should aim to highlight the risks that are associated with its chosen strategies and, notably, be able to quantify and monitor its overall exposure to these risks. Managers are also required to report any violations in regulations to the Financial Sector Conduct Authority (FSCA), along with a motivation detailing the date of the breach and the process that was undertaken to rectify it.