Hedge funds offer investors unique opportunities to diversify their portfolios and potentially enhance returns, but they come with distinct strategies and risks. This article answers the most common questions about hedge funds, from how they work to the regulatory protections in place for South African investors.

What are hedge funds?

Hedge funds are alternative investment vehicles designed to deliver positive returns regardless of whether markets are rising or falling. They invest in a wide variety of asset classes and instruments, using advanced trading strategies and portfolio construction methods compared to traditional collective investment schemes.

What are the benefits of hedge funds?

By employing a multitude of investment strategies and philosophies, hedge funds offer investors unique return profiles that are generally uncorrelated to the market. As part of a well-balanced strategy, hedge funds can potentially enhance returns and lower overall portfolio risk.

What investment strategies do hedge funds use?

Hedge funds use unique investment strategies that carry some risk. To provide returns less correlated to market movements, they often use leveraging, short-selling, derivatives, and unlisted instruments.

  • Leverage and derivative structures can amplify returns but may also increase volatility if not managed properly.
  • Trading in unlisted instruments can result in price fluctuations after daily price publication, as values may be estimated and less accurate in the short term.
  • Scrip borrowing and lending introduces the risk of default by the prime broker or custodian.
  • Investments in illiquid instruments may delay repurchases, and managers may suspend repurchases in exceptional circumstances, subject to regulatory approval.
  • Short-selling can lead to short-term losses if the value of the underlying shares increases.

How risky are hedge funds?

Risk management is a cornerstone of hedge fund management. Regulations require higher levels of transparency and disclosure, and management companies must monitor for breaches of risk limits. The risk and return profiles of hedge fund strategies can differ greatly, so it’s important to understand each fund’s philosophy before investing. Regulation 28 limits total exposure to hedge funds to 10% for diversified portfolios.

Are hedge funds regulated?

In South Africa, hedge funds have been regulated as collective investment schemes under the Collective Investment Schemes Control Act (CISCA) since 2016, offering investors enhanced disclosure and protection.

What type of fee structures are applied to hedge funds?

Hedge funds typically charge both fixed and performance fees. Performance fees often include a hurdle rate and high-water mark policies, ensuring managers only earn fees for returns above a minimum rate and that investors don’t pay for the same performance twice. All fees and charges are disclosed in quotations and minimum disclosure documents.

Common Hedge Fund Strategies

  • Long/Short: Buying undervalued assets (“long”) and selling overvalued ones (“short”) to profit from price movements and reduce overall risk.
  • Market-Neutral: Balancing long and short positions to target zero net market exposure, focusing on exploiting short-term mispricing while hedging market risks.
  • Global Macro: Capitalizing on trends and economic outlooks by analyzing economic variables and their market impacts across asset classes.
  • Fixed-Income Arbitrage: Profiting from pricing inefficiencies in the fixed income sector, often using derivatives.
  • Multi-Strategy: Combining various strategies for more stable returns and reduced volatility.
  • Statistical Arbitrage: Using quantitative models to exploit short-term pricing inefficiencies in large, diversified portfolios.

Glossary of Common Hedge Fund Terms

Term Definition
Alpha Excess return from a portfolio over a benchmark.
Beta Measure of a portfolio’s volatility compared to the market.
Benchmark Standard against which portfolio performance is measured.
Counterparty Risk Risk that a party in a transaction fails to meet obligations.
Default Risk Risk that a party cannot make required debt payments.
Derivatives Financial instruments linked to underlying assets, often used for risk transfer or leverage.
High-Water Mark Ensures investors don’t pay performance fees more than once for the same gains.
Hurdle Rate Minimum return required before performance fees are charged.
Leverage Borrowing to increase exposure, which can magnify gains or losses.
Performance Fee Fee charged on profits above a benchmark or hurdle rate.
Scrip Borrowing/Lending Temporary borrowing of shares for a fee.
Short-Selling Selling borrowed shares to profit from price declines.
Unlisted Instruments Assets not traded on formal exchanges, often less liquid.

 

Graviton Financial Partners (Pty) Ltd is an authorised financial services providers in terms of the Financial Advisory and Intermediary Services Act,2002. The information in this article does not constitute financial advice While every effort has been made to ensure the reasonableness and accuracy of the information  contained in this article (“the information”), the FSP, their shareholders, subsidiaries, clients, agents, officers and employees do not make any  representations or warranties regarding the accuracy or suitability of the information and shall not be held responsible and disclaim all liability  for any loss, liability and damage whatsoever suffered as a result of or which may be attributable, directly or indirectly, to any use of or reliance  upon the information.