Hedge funds, like other collective investment schemes, pool investors’ money, and appoint a professional manager with the necessary qualifications to invest in shares, bonds and other securities in line with the fund’s investment mandate.
The key difference, however, between South African regulated hedge funds and other collective investment schemes in securities, is that hedge funds use more strategies with the aim of earning a positive return regardless of whether markets are going up or down.
HOW DO HEDGE FUNDS HEDGE?The two key strategies that hedge funds use to earn positive returns, regardless of what is happening in markets, both involve the use of derivatives. Derivatives are financial securities that derive their value from other securities. Unit trust funds can only use derivatives to protect the fund against a fall in the prices of the shares, bonds or other securities that they actually own. Hedge funds can, but unit trusts cannot, engage in:
Hedge funds can also hedge against market falls by moving 100% into cash while most unit trust funds must be at least 80% in the market at all times. |
Index-tracking funds, such as exchange traded funds (ETFs), make money when the markets go up, and actively managed funds, such as unit trusts, try to beat rising markets and lose less in falling markets
Hedge funds, however, use a wider range of investment strategies in an attempt to earn positive returns when markets are rising or falling. This is how hedge funds got their name – they aim to hedge against falling markets.
The wider range of investment strategies they can engage in includes borrowing to invest – known as gearing, and selling shares or bonds or other securities the manager does not own – known as shorting securities.
Gearing means the manager uses derivatives to amplify its investment decisions.
This can increase the volatility of the fund, and borrowing incurs interest the fund, must pay. Gearing can increase the fund’s gains, but can also increase its losses.
Hedge funds may also invest in unlisted instruments, bonds or other debt that credit rating agencies have rated poorly, and foreign currency instruments.
Unlisted instruments can be incorrectly valued because they are not trading on an open market where prices reflect immediately as investors value them. Borrowers could default on low grade debt, and currency bets can turn against the fund.
These strategies can make hedge funds more risky than other funds, but not all hedge funds make use of all the investments or investment strategies to the full extent to which they are allowed. This in turn affects the level of risk involved in investing in them. You need to establish what the fund’s strategies are before you invest.
As hedge funds are entitled to use different strategies to those used by traditional unit trust funds and ETFs, they register with the Financial Sector Conduct Authority and operate under hedge fund regulations issued in terms of the Collective Investment Schemes Control Act (Board Notice 52).
In 2015 South Africa declared hedge funds to be collective investment schemes subject to hedge fund regulations – the first country in the world to do so. The regulations provide for two kinds of hedge funds:
These funds – sometimes referred to as hedge fund lite - are available to any investor with enough money to meet the minimum investment requirement, and the fund’s investment activities are more strictly regulated, making the risks it can take more limited.
Qualified investor hedge funds
These funds are only available to investors who have R1 million or more to invest. Investors must demonstrate that they have sufficient expertise to understand the risks of investing in hedge funds, or they must invest through a financial adviser who is qualified to advise on the merits and risks of investing in a hedge fund.
