The future of hedge fund strategies in SA

BY RAYHAAN JOOSUB Portfolio Manager and Director, Sentio

Sentio has always advocated that the two key ingredients to making a good hedge fund are uncorrelated returns, and positive asymmetry. We would like to unpack these two concepts in more detail from a strategy perspective and hope this will assist allocators in their selection of hedge funds.

Uncorrelated returns – Alternative risk premia

Like long-only funds, many hedge funds leverage traditional risk premia like the equity-risk premium and duration-risk premium to generate the bulk of their returns. The problem with this is that it creates significant concentration of risk among different hedge funds, which results in a higher correlation of returns. Returns are great when those risk premia are delivering positive returns, but when those risk premia experience corrections, for example when equities or bonds sell off, most funds will deliver poor outcomes simultaneously.

It is the job of hedge fund managers to find alternative risk premia within traditional asset classes like equities and bonds, and within other asset classes that are relatively uncorrelated with the traditional risk premia. Alternative risk premia provide diversification benefits and, as a result, better risk-adjusted returns, especially when equity and bond market returns come under pressure. Currently, these alternative risk premia are not easy to find and require sophisticated quantitative and machine learning techniques to extract the rewarding strategies implicit in the equity and bond markets (which are also independent of the equity and duration risk premium).

Very often, the returns from these alternative risk premia are quite low and will require careful leveraging to achieve attractive returns relative to traditional risk premia. Since hedge funds are allowed to leverage, as opposed to their long-only counterparts, this is a key differentiator for hedge funds. Hence, hedge funds that use leverage intelligently can emphasise returns from diversified sources and thus provide far better risk-adjusted returns than long-only funds.

Positive asymmetry – Managing the upside relative to the downside

Another key ingredient that makes a good hedge fund is the ability to provide positive exposure to risk premia when they provide positive returns, and reducing that exposure before they produce negative returns. Too many hedge funds have failed to do this and typically ride the wave on the upside while earning performance fees, then subsequently fail to protect capital when the wave turns negative.

A ‘good’ hedge fund needs to manage the upside relative to the downside, and using machine learning as well as fundamental, quantitative and derivative techniques help to achieve this. Common wisdom holds that ‘timing is everything’ but it is also true that ‘timing is difficult’. However, we believe that when risk premia do not provide appropriate upside relative to the downside risk, then it is the job of the hedge fund managers to manage the downside risk to that asset or strategy, or allocate to other assets or strategies that offer better risk-adjusted returns. ‘Chasing’ returns with high leverage is very dangerous and has led to most of the ‘accidents’ in South Africa’s hedge fund industry. At Sentio, we pride ourselves on our machine learning and risk management capabilities, and incorporate alternative risk premia and asymmetric returns into our hedge fund strategies so that we can achieve our objectives without taking excessive risk.