Funds of hedge funds protect investments

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.

"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," De Waal says. "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."

An efficient tool

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).

Quality of management

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.

Looking ahead, De Waal 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."