Funds of hedge funds take the legwork and risk out of investing in hedge funds

A good fund of hedge funds should represent less risk than the sum of its parts, the individual hedge funds that are its building blocks.

Carla de Waal, Head of Alternative Investment Solutions at Novare Investments, says that funds of hedge funds help investors to protect their total portfolios against severe market downturns so that investments can compound at a stable rate.

“Hedge funds represent a fairly small proportion of the investment universe in South Africa, but they can make a big difference in terms of reducing risk in a portfolio,” she says.

Assets in the South African hedge fund industry total some R40 billion, compared to the long-term savings system with assets of around R4.6 trillion. Where hedge fund strategies are concerned, most assets are managed in equity-based funds, followed by fixed interest.

According to de Waal, “The majority of local hedge funds are conservatively managed, with the focus on capital preservation. This encourages their use as risk reducers in portfolios, rather than return enhancers. Hedge fund mandates also consistently include reference to their long-term investment objective of capital preservation, avoidance of negative compounding, capital growth and generating positive returns regardless of market direction.”

The strategy and approach of many hedge funds is rooted in fundamental analysis, a similar process followed by many traditional long-only unit trust managers. Their mandates, however, allow hedge funds to more actively hedge risk using short positions and derivatives, making them an efficient risk management tool in an investor’s total portfolio.

De Waal notes that funds of hedge funds, the largest allocators of money to local hedge funds, have played a definitive role in shaping the industry, including implementation of best practices, with the result that most hedge funds use an independent third party administrator for valuation and prime brokers for dealing and execution.

Of additional reassurance to investors is that the industry is highly regulated. The final element, the regulation of hedge fund products (as opposed to already regulated managers), is currently being worked on by the industry in conjunction with the National Treasury and the Financial Services Board (FSB).

When it comes to constructing fund of hedge fund portfolios, de Waal says the starting point is to determine the needs of investors and the role that an allocation to alternative investments should play in the portfolio. Novare’s process of building its funds of hedge funds starts with initial qualitative and quantitative screenings of managers to arrive at a short list for detailed due diligence investigation.

During this process, each hedge fund business is evaluated, looking at the quality of management and whether assets under management are sufficient to cover all operating costs. A team separate from the investment committee is responsible for operational due diligence, while the investment team reviews each manager’s investment philosophy, thesis and strategy, decision-making process, portfolio construction process and approach to active risk management of the portfolio.

Says de Waal: “We want to determine whether the investment process is robust, consistent, sustainable and scalable through different market conditions. We also need to determine early on the risks unique to each strategy.”

Looking ahead, she believes the market will continue to see innovation from funds of hedge funds in constructing portfolios that fulfill a specific purpose for clients. “Product offerings over recent years have expanded to include a whole suite of different risk-profiled portfolios, or building blocks that offer investors a broader choice.”