South African hedge funds make use of strategies that fall into the following categories:
Equity long/short funds
This is the most popular strategy for South African hedge funds. These funds take both long investment positions – they buy and hold stocks they expect will go up in value - and they short others – or sell stocks they do not own - if they think the price of the stock is going to fall (read How hedge funds hedge). Most of these funds have more long positions than short positions.
Equity market-neutral funds
Like equity long/short, funds these funds take both long and short positions, but instead of targeting a return that beats the market by a certain number of percentage points, equity-neutral funds aim to achieve an absolute return – one that is not linked to the market and will always be positive regardless of what equity markets return. They take similar long and short positions of similar sizes in different shares with the aim of an outcome that is positive and not up or down with the market.
Fixed-income funds
These funds buy and hold some fixed income instruments and short sell others to take advantage of the different prices of the instruments, their yields and the risk that the lender may default (credit risk).
Managers may take leveraged bets (use derivatives to amplify the return) on how interest rates and the yield curve will move – for example, they may buy bonds with long terms to maturity if their interest rates are likely to increase and sell bonds with short terms if their interest rates are likely to decrease.
These funds often use derivatives to increase their exposure and boost what would otherwise be modest returns. This, however, increases the risk as the manager’s bets may be wrong.
Multi-strategy funds
These funds use a variety of underlying hedge fund strategies and may invest across asset classes.
Other strategies
Other strategies used in South Africa are those involving quantitative models (mathematical and statistical modelling) to identify investment opportunities and take short-term positions involving a large number of securities.
Some managers also use a strategy known as volatility arbitrage to exploit mismatches in prices of derivatives on similar instruments. The value of derivatives is impacted by the volatility of the underlying security. Pricing mismatches arise when there are different views on how volatile the underlying security will be.
One specialist hedge fund in South Africa uses this strategy when investing in agricultural, energy-related and commodity derivatives.
