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HEDGE FUNDS IN SOUTH AFRICA THE INVESTMENT CASE

By S. J. B. Peile BBusSc, AIAA, CFP, FASSA, FFA and W. S. van der Merwe BSc (Actuarial), BCom (Hons in Financial Analysis), CFA (Presented to the Actuarial Society of South Africa, 13/14 October 2004)

Introduction Many South African institutional investors already have some exposure to hedge funds within their investment portfolios, most likely through an investment in a global fund of hedge funds. Increasingly local institutional investors are also investing in domestic hedge funds. In this paper we review the South African hedge fund market and make comparisons with the global hedge fund market. Actuaries are often involved with institutional investors and their investment strategies. The actuary may be a senior officer of an insurance company, or an investment professional employed by an insurance company, but more often, actuaries will be involved with assisting boards of trustees of retirement funds with developing investment strategies that suit the investment objectives determined by the funds liability profile. Actuaries in these roles should therefore have a reasonable understanding of the local hedge fund market and the role that hedge funds can play in investors portfolios. Many actuaries will already be familiar with the work carried out on the global hedge fund market where a case is frequently made for an exposure to hedge funds within a balanced portfolio based on their attractive returns, the low volatility of these returns and the low levels of correlation of these returns with the returns of other major asset classes. We examine whether the same case can be made for investment in local hedge funds based on their performance histories. Hedge funds are seen by many to be clouded in mystique. They often receive bad reviews in the popular press, with hedge fund managers being caricatured as investment cowboys. We try to provide a more balanced perspective of the industry. One difficulty we have is that there is no simple definition of what a hedge fund is. The broad category includes funds following a wide variety of strategies with very different approaches to managing risk. The popular perception of hedge funds is that of gung-ho day traders willing to exploit any loophole to make money with little concern for risk. We hope to show that the vast majority of hedge funds operate quite differently and it is the latter type of hedge fund that should be most attractive to institutional investors, even if they make for less sensational reading. We hope to show that most hedge fund managers are both more conscious of investment risk and better equipped to manage it than most traditional asset managers. Through detailed analysis, the investor should ultimately be able to understand the potential risks and opportunities inherent in different hedge fund strategies and be able to separate competent hedge fund managers from pretenders. One can learn a lot about hedge funds simply by examining the return numbers in great detail. But that should not be sufficient for the professional advisor. One also needs to understand how these returns are

generated, what the techniques are for generating returns and what the techniques are for managing risk in the portfolios. By understanding how hedge fund managers manage their funds we are able to understand their performance numbers better. By interrogating their performance numbers in depth, we are better able to appreciate better how they manage their portfolios. By doing both, we hope to gain an understanding of the likelihood that hedge funds will continue to deliver attractive low volatility returns into the future. The relatively short history of hedge funds in South Africa, the relatively small number of funds that are available and the broad definition of hedge funds, all contribute to making the production of representative hedge fund return data a challenge. We have produced a series of South African hedge fund return indices for the purpose of analysis, the methodologies behind which we describe in the appendix. Actuaries will recognise the limitations that arise from the size of the universe available to us, but that is a reality that we have to accept. What gives us comfort in our conclusions is that none of these differ from those derived from global hedge fund performance statistics which are based on over 50 years of history and thousands of hedge funds. We also discuss some of the issues that investors looking to invest in hedge funds should consider before making an investment. We look at the benefits of diversifying between hedge funds and the importance of both strategy and manager selection. We introduce the fund of hedge funds concept. In the global environment the terms hedge fund and absolute return fund are usually interchangeable. However, in South Africa a number of investment products have been launched in recent years under the label of absolute return funds but which are not hedge funds. These are generally funds that seek to deliver lower volatility returns to their investors than those delivered by conventional funds, but without using the explicit downside risk management techniques employed by hedge funds. At the end of the paper we take a small detour to investigate whether applying the same techniques we have identified to analyse hedge funds can assist us to improve our understanding of some of these absolute return funds. Throughout the paper we refer to both hedge fund managers and investors in the masculine. This is done only to avoid the clumsy alternative forms of presentation. If we offend anyone, we apologise in advance. An important feature of hedge funds is that they are an extremely heterogeneous group of investment funds. There are few characteristics that apply to each and every hedge fund that one encounters. We therefore frequently use the terms usually, mostly, normally, generally etc. reflect the characteristic being described. While this may seem repetitious it is preferable to creating the misperception that every fund that calls itself a hedge fund will

1. 1.1

AN INTRODUCTION TO HEDGE FUNDS Regulation

Hedge funds are investment funds that operate on a private basis and as such are not regulated by the Financial Services Board (FSB) in South Africa. framework. regulated. Hedge funds are not regulated because they typically employ strategies, such as short selling and the use of leverage, that fall outside of the current regulatory In most geographical regulatory jurisdictions hedge funds are either unregulated or lightly In March 2004 the FSB together with the local chapter of the Alternative Investment

Management Association (AIMA) and the Association for Collective Investments (ACI) published a joint discussion paper regarding a proposed regulatory approach for hedge funds in South Africa. Hedge fund managers must be approved by the FSB as fund managers. This approval to manage assets should not be confused with any form of regulatory approval of the hedge fund itself. The implication for hedge funds of not being regulated is that they are not allowed to market themselves to investors. Investors who approach a hedge fund manager and wish to invest in the fund are permitted to do so. Current investors in South African hedge funds are typically sophisticated investors, or are investors that have access to expert investment advice. Current investors in South African hedge funds usually invest directly in the fund (if the investor is large) or through an insurance policy linked to an investment in the hedge fund by the insurance company. Insurers may not invest in hedge funds unless the hedge fund is housed in a limited liability structure, limiting any potential loss by the insurer to the amount of capital invested by the insurer in that hedge fund and thereby protecting all other policyholders from any contagion risk should the hedge fund incur losses greater than the total capital invested in the fund. Regulation of the South African hedge fund industry is likely to result in a wider spectrum of investors investing a portion of their assets in hedge funds. In particular, regulation of the local hedge fund industry is likely to take bring hedge funds under the umbrella of the Collective Investment Schemes Act, and result in hedge funds being offered in the form of unit trust investments targeted at retail investors. Regulation will also provide greater comfort to other investors that hedge funds are an acceptable form of investment. Importantly, regulation will not remove the risks associated with investing in hedge funds, in the same way as regulation of conventional collective investment schemes does not remove the risks associated with investment in these funds. Prospective investors in hedge funds should seek to understand the risks associated with investing in hedge funds and how these risks can best be mitigated. One objective of this paper is to assist South African actuaries involved in the investment advisory field to achieve this. 1.2 A brief overview of hedge funds

The hedge fund industry is relatively new in South Africa, with a meaningful history of only about six years. This contrasts with the global market where hedge funds have been operational for more than half a century. industry. In all aspects, the domestic hedge fund industry is less well developed than the global There are relatively few hedge funds operating in the country, the proportion of total assets

invested in hedge funds is lower and the types of strategies followed by domestic hedge funds are fewer and generally broader than encountered in the global arena. There is no simple definition that describes a hedge fund. As a categorisation, it covers a heterogeneous group of investment funds. If there is a single common characteristic it is that hedge funds focus on Hedge funds delivering to their investors attractive positive returns irrespective of market direction. How they do that and how well they deliver on their objective differs from hedge fund to hedge fund. offering a wide variety of risk/return profiles. encompass a wide variety of different investment objectives, strategies, styles, techniques and assets, While the majority of hedge funds focus on delivering attractive returns at low risk, there are also hedge funds that follow high risk strategies with the objective of delivering higher returns. Although these funds tend to be the minority, they do however represent the popular perception of what a hedge fund is. Conventional investment funds, referred to within the hedge funds industry as long-only portfolios, tend to be highly correlated with the market indices that represent the markets within which they operate. This is a concept familiar to most practitioners who work with long-only portfolios and is not surprising given that a properly diversified long-only portfolio rapidly assumes characteristics similar to the market index. The degree of commonality can be measured in terms of the sensitivity of the portfolios change in value that can be explained by any change in value of the market index and this factor is known as the portfolios beta to the market. A typical general equity portfolio will have a high beta to the equity market (0.9 to 1.1) and therefore, the value of the portfolio will be very sensitive to any changes in the value of the equity market as a whole. As a result, when the equity market performs badly, almost all long-only equity portfolios will also lose in value. An asset manager who wishes to consistently achieve positive returns in negative equity markets as well as in positive equity markets must therefore hedge out the effect of the market. managers hedge out market risk through short selling. In the discussion below we use the equity market to illustrate various techniques utilised by hedge fund managers. The majority of hedge funds in South Africa operate predominately or exclusively in the local equity market. The techniques used can however be applied in almost any market and in relation to any asset class, including fixed interest instruments, commodities and currencies. In the global hedge fund arena one encounters hedge funds operating in almost every market where there is an opportunity to trade instruments. One even encounters wine hedge funds. 1.2.1 Short Selling Hedge fund

Short selling involves borrowing a security that you do not own, in order to sell the security in the open market with the objective of buying it back later at a price lower than it was sold for in order to return it to its original owner, whilst profiting from the fall in price. Conventional trading strategies focus on first buying low and then selling high. high, then buy low. Short sellers merely reverse this order first sell

Long term holders of securities are often willing to lend out a proportion of their holding in order to benefit from a scrip lending fee. The hedge fund manager does not have to source the scrip directly from the lender as this is generally done by the hedge funds prime broker. The lender can generally recall the lent scrip at any time, but in most cases the prime broker should be able to find a substitute lender, which would mean that the hedge fund manager does not have to buy back the scrip before he had intended to. When a hedge fund sells a security short it receives the proceeds of the sale (less the scrip lending fee and a margin) in the form of cash and the fund can then either retain the proceeds in cash and earn interest on it, or can use the proceeds to purchase additional assets for the portfolio, thereby leveraging the funds exposure. In addition to being obliged to return the scrip to the lender should it be recalled, the borrower is obliged to make the lender good for any dividends paid out to shareholders over the period when the scrip is out on loan as these will have been paid to the new owner of the share, and not to the original owner of the share. The borrower is therefore required to pay the dividend to the lender out of his general assets. This payment is known as a manufactured dividend. Share prices do not always drop by the full amount of the dividend paid when a share goes exdividend. happens. The greatest risk in short selling is that against expectations, the price of the share does not fall, but rather it increases. In that case, the borrower will have to pay more when he comes to buy the share back than he originally sold it for, and he will incur a loss on the trade. Long-only portfolio managers lose money when the price of an asset which they hold goes down. The maximum loss that they can incur is what they paid for the asset, and that is only if the price of that asset reduces to zero. The potential losses from short selling are, however, unlimited. If the investor starts with capital of R1000 and uses this capital as security to borrow R1000 of scrip which he sells short, he is then in a position where he holds R2000 in cash and has a liability of R1000 in respect of the short position. Cash Short Position Net Asset Value R2000 R1000 R1000 This is a risk to the borrower of scrip, as the hedge fund will pay out a greater manufactured dividend than it will profit from the fall in the price of the borrowed scrip if this

If the price of the share that has been sold short goes up by 50% to R1500, then the investors liability in terms of the short sale rises to R1500 and the investor has lost 50% of his initial capital. Cash Short Position Net Asset Value R2000 R1500 R 500

If the price of the share doubles, he loses his entire capital, and if the price trebles he must pay in as much again as he initially invested. If the price were to rise high enough his losses could be very high indeed. Short selling is not simply the inverse of conventional long-only investment management and professional investors such as hedge fund managers, who are involved in short selling, manage the risks associated with their short exposure keenly. 1.2.2 Uses of short selling

The ability to engage in short selling is a major differentiator between hedge funds and long-only funds. Short selling allows the hedge fund manager to engage in one or more of the following strategies: 1.2.2.1 Selling shares perceived to be over priced and expected to fall.

Similarly to the long-only manager the hedge fund manager uses fundamental analysis to identify, shares that are considered to be overvalued where there is a reasonable expectation that the price will correct downwards. Unlike the long-only manager, by shorting the overpriced share, the hedge fund manager is able to profit from the analysis that he has conducted on the share should the price fall. The long-only manager has less potential to benefit from correctly identifying overpriced shares. He is limited to selling the share if he already owns it in order to reflect his pessimistic view by either not holding it or often by simply holding a below benchmark weighting in that share. If he does not hold the share, he can not benefit from his analysis. 1.2.2.2 Pair trades

A pair trade involves taking offsetting long and short positions in related securities in order to benefit from an expected change in the relative price relationship. By taking a long position in the relatively underpriced share and a short position in the relatively overpriced share, the hedge fund manager expects to profit if the price gap between the shares narrows whilst protecting the portfolio against price movements resulting from features common to the two shares. The price of a particular share can change either as a result of issues unique to the particular business in question, or from factors which the business has in common with other businesses either the whole market, that industry or sector of the market, or other businesses affected by the same economic factors. A pair trade made up of a long position in ABSA Bank and a matching short position in First Rand, for example, will make money if the price of ABSA shares rises more quickly, or falls more slowly than the price of First Rand shares. The portfolio should be protected against any fall in the overall market, in the financial sector, the banking industry, or in interest rate sensitive stocks, as any losses incurred on the long ABSA position should be offset by profits earned on the short First Rand position. common factors. Figure 1.1 shows the price history of both shares since the beginning of 1998. The relationship Likewise, the fund will not profit from any general gains arising from

between the prices of the two shares should be reasonably obvious even through casual study. This

was particularly evident in the recent past. It should also be evident that significant divergences can also occur between the two prices.
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Figure 1.1: Share prices for ABSA and First Rand based to 100 in January 1998

Figure 1.2 shows the long ABSA, short First Rand pair trade history in greater detail over the more recent past. As both shares are very liquid a hedge fund manager would be comfortable taking short positions in either share and is therefore able to exploit the price relationship whichever of the two shares becomes expensive relative to the other. If one assumes for illustrative purposes that the manager will place a trade whenever the price relationship breaks back through the Bollinger bands positioned 1.7 standard deviations around a 32 day moving average of the relative prices, exiting the trade either profitably should the price relationship revert to the moving average, or making a loss if the trade loses 2% from the level it was executed at, one can identify 16 opportunities to place the trade over a 14 month period. Fifteen trades would have yielded a profit and one would have triggered a stop loss. (Both prices exclude dividends which in practice would have to be factored in). Pair trades need not be confined to two shares in the same sector if the two shares can be shown to have common price drivers. Pair trades can also be constructed using baskets of shares where each basket has common offsetting features and the hedge fund manager has reason to believe that the one basket has good reason to perform better than the other. Pair trades allow hedge fund managers to take risk in areas where they believe that they have a competitive advantage (for example, stockpicking based on fundamental analysis) and to hedge out risks over which they have no control and have no ability to anticipate (overall market direction).

Pair: ABSA Group vs. FirstRand Group


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Figure 1.2: Long ABSA, short First Rand (April 2003 to July 2004)

1.2.2.3

Arbitrage trades

Arbitrage trades are similar to pair trades other than with arbitrage trades the relationship between the two securities should be closer. Pure arbitrage refers to purchasing a commodity in one market and selling it immediately in another market at a profit. In the global market place such riskless arbitrage trades are no longer possible in any meaningful way, and today arbitrage more usually refers to being long and short very closely related securities when the price relationship between them has widened temporarily, in order to benefit when the relationship reverts to its historical position. An example of an arbitrage trade in the local context is to be simultaneously long of Liberty Holdings and short of Liberty Group. The two shares have an intrinsic relationship and there should be no fundamental reason why the two share prices should break out of their historical relationship. The two shares are however subject to different supply and demand forces, which will result in shortterm changes in their relative prices from time to time. As the hedge fund manager can have very strong conviction that the price relationship will normalise within a reasonable timeframe, a long position in the relatively underpriced share and a matching short position in the relatively overpriced share, should deliver low risk profits. Figure 1.3 shows the price history of both shares over the past five years. The very close relationship between the two prices is evident.

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Figure 1.3: Share prices for Liberty Holdings and Liberty Group based to 100 in October 1999

In Figure 1.4 we consider the long Liberty Holdings, short Liberty Group trade in closer detail over the more recent past. The relative prices are tracked as well as Bollinger bands based on 32 day moving averages plus or minus 1.7 standard deviations. The figure shows seven opportunities to enter this trade when the relative price having broken out of its close price relationship, breaks back in. Each trade was profitable. Note that only long Liberty Holdings, short Liberty Group trades were considered despite the diagram showing profit opportunities from the long Liberty Group, short Liberty Holdings trade, as few hedge fund managers would be comfortable shorting an illiquid stock such as Liberty Holdings.

Pair: Liberty Holdings vs. Liberty Group


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Figure 1.4: Long Liberty Holdings, short Liberty Group (April 2003 to July 2004)

1.2.2.4

Leverage

As short-selling generates proceeds from the sale of the borrowed security, the hedge fund manager has the choice of either retaining this money as cash and earning interest on the cash, or of using this money to create additional long exposure to selected securities, thereby leveraging the overall portfolio. As the long/short process consumes minimal capital if the positions are matched, it is possible to reiterate the process a number of times and create additional leverage in the portfolio simply through the long/short process. 1.2.3 Leverage

In addition to short selling, the other frequently encountered technique used by many hedge funds is the use of leverage. Leverage can be defined as creating an exposure within the investors portfolio greater than the capital invested. Leverage, or gearing, can be achieved by borrowing money to invest in the portfolio. The use of leverage can greatly increase the returns to the investor when the returns achieved on the total portfolio exceed the costs of borrowing, but leverage can also significantly increase the risks associated with investing. Not borrowing money for the purpose of investment is one of the investment lessons we are taught very early on in our investment lives, and ironically ignore almost immediately when investing in our first residential property. Many hedge funds employ leverage in order to benefit from identifying low-risk profit opportunities whose expected returns are also low. By leveraging the trade, the return potential of that trade becomes more attractive. Leverage, however, like shorting introduces the potential of losing more money than the capital invested. The degree of leverage employed should therefore be appropriate relative to the risk inherent in the leveraged strategy.

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Most local hedge funds achieve leverage through the long/short process rather than by borrowing monies to invest in the portfolio. 1.3 Hedge Funds Defined While there may be no simple definition of a hedge fund, the Financial Services Board, in its white paper of March 2004 (The Regulatory Position of Hedge Funds in South Africa, A Joint Discussion Paper) proposed the following definition: Funds that utilise some form of short asset exposures or short selling to reduce risk or volatility, preserve capital or enhance returns or funds that use some form of leverage, measured by gross exposure of underlying assets exceeding the amount of capital in the fund. This is a very wide definition, but one that encapsulates the key factors that differentiate the wide category of investment funds that might call themselves hedge funds, from conventional investment funds where shorting and leverage are not permitted. The definition as set out does however include those portfolios where the portfolio manager hedges out market exposure using representative market futures. It is likely that this type of fund will not be treated as a hedge fund from a regulatory perspective as long as the funds net exposure (long stock exposure, less short market exposure) remains between 0% and 100% at all times. 1.4 Hedge Fund Characteristics

Given the wide variety of hedge funds encountered and the limited insight gained from any definition of hedge funds, it is useful to describe some of the most common features of most hedge funds. It should be stressed however that none of these features are required of a hedge fund, but rather that they are characteristic of the majority of hedge funds. Focus on delivering positive returns irrespective of market direction Complex investment strategies Considerable investment freedom Strong focus on performance Significant own capital invested in fund Performance based fee structures Limited capacity in terms of assets that can be managed Trading orientation Limited liability structure Small investment team Outsourced back office infrastructure Limited liquidity Strong focus on risk management

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1.4.1

Positive Returns Irrespective Of Market Direction This is

Hedge fund managers monitor their portfolios sensitivity to market movements closely.

achieved by measuring the portfolios net exposure (total long exposure in Rands, less total short exposure in Rands) or the portfolios net beta-adjusted exposure, where each portfolio constituent is adjusted for its sensitivity to overall market price movements. Not all hedge funds exclude all market direction risk from their portfolios at all times. Many hedge funds are willing to take directional risk when the managers consider that appropriate, or when the opportunity set of attractive investment ideas is skewed in favour of either long or short (but generally long) ideas. 1.4.2 Complex Investment Strategies Hedge funds can follow more complex investment strategies by taking short

Many long-only portfolios can be simplified down to overweight and underweight positions relative to a benchmark index. positions as well as long positions, and by leveraging their portfolios. Hedge funds can follow very narrowly focused strategies, or they can allow themselves the freedom to move rapidly between different markets as and when they see opportunities to earn profits. They can restrict themselves to conventional securities or they can seek to profit from the mispricing of complex derivative instruments. 1.4.3 Investment Freedom Hedge funds rely on inefficiencies in investment markets in

In comparison to conventional long-only managers, hedge fund managers are required to be more flexible in their investment approach. order to deliver above-cash returns to their investors. Such inefficiencies are not always found in the same areas of the market. By exploiting inefficiencies in one area of the market, hedge funds tend to create greater overall efficiency. The hedge fund manager therefore needs to be constantly on the look-out for new areas to make money. Hedge funds must remain nimble in their approach. 1.4.4 Focus on Performance, Co-investment, Performance Fees The fund manager is usually incentivised to deliver attractive

The interests of hedge fund managers and their investors are usually very closely aligned when it comes to investment performance. returns in two ways. Firstly, hedge fund managers typically co-invest in their fund together with their investors on the same terms and conditions. Where the manager has a significant portion of his own wealth invested in the fund, the returns earned on the fund can meaningfully influence the managers wealth creation. Secondly, the hedge fund manager usually participates meaningfully in the The fees charged by hedge fund managers performance through a performance participation fee.

vary from fund to fund, but generally there is a basic fee of the order of 1% of market value per annum, and a performance fee of around 20% of the growth achieved by the hedge fund manager. There are various conditions attached to the earning of performance fees such as the achievement of minimum hurdle rates of return, and the application of high-watermarks, but in most cases the business model relies on the receipt of performance fees in addition to the basic fee for the business to be sustainable.

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1.4.5

Capacity Constraints

Hedge fund managers generally aim to manage an optimally sized portfolio, rather than to maximise the size of the assets that they manage. An optimally sized portfolio is one where the size of the portfolio is large enough to provide an asset base to generate fees on, but not so large that performance is hindered. Conventional asset managers generally earn larger fees if they manage a larger pool of assets. Investment performance is only one of the factors that will influence their ability to gather assets. Marketing capability and distribution networks can often be more influential than historic investment performance. Hedge funds are limited in terms of the size of assets that they can optimally accommodate. Where the fund takes advantages of inefficiencies in investment markets, as the size of the portfolio being managed grows, the attractiveness of many investment opportunities reduces. Many such opportunities have a profit potential in absolute Rand terms, rather than in percentage of capital invested terms. The potential return from such opportunities, when expressed in percentage terms clearly reduces as the size of the portfolio grows. As a result, as a portfolio grows, the manager may reject opportunities he may have exploited had the fund been smaller. Where the manager has a significant portion of his own assets invested in the fund, and where the business model relies on the achievement of performance fees, the hedge fund manager will seek to limit the size of the portfolio he manages to that which will not inhibit his ability to deliver attractive returns on the capital in the fund. Risk management is critical in managing hedge funds and hedge fund managers employ a wide variety of risk management tools and strategies. Stop loss strategies are widely employed to minimise losses and to protect capital. The effectiveness of stop loss programmes depends on the ability to exit the trade quickly when the trade turns against the hedge fund manager. Liquidity is an important factor in effectively managing stop losses in portfolios. loss can be effected. Consequently hedge funds typically have maximum caps on the size of the assets that they will accept. Many funds soft-close when they have a suitable spread of investors, but continue to accept new cashflow from these investors until the fund reaches its ultimate limit when it will hard-close. Some funds may open again to accept further assets if market liquidity improves and the manager is confident that accepting additional assets will not prejudice future returns. 1.4.6 Trade Orientation The larger the exposure to a particular trade, the greater the risk that the price can run through a stop loss level before the stop

A hedge fund is made up of a portfolio of trading ideas that are in play at any moment in time. The default position is cash and the hedge fund manager is not obliged to place trades if he is unable to identify any trades which are expected to deliver returns in excess of the return expected on cash. The hedge fund manager, in addition to measuring the returns achieved on the portfolio as a whole, will usually also measure the success of each trading idea separately as well as each category of trading idea.

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Trades could be made up of single stocks, for example an unhedged independent long position in a share. Alternatively they could be made up of more than one stock, such as a long/short pair or a basket. The success of the trade is measured in terms of the return achieved on the overall trade rather than on each of the constituent parts of the trade. Success analysis is usually broken down between profitable and unprofitable trades, and then further analysed in terms of the size of the profit or loss. to exceed the average size of his losing trades. 1.4.7 Limited Liability Structures The hedge fund manager aims to increase his success rate in terms of profitable trades above 50% and for the average size of his profitable trades

The use of leverage and shorting in hedge fund portfolios introduces the possibility of the portfolio losing more capital than that employed in the portfolio. In such a case investors may not only lose the capital that they originally invested, but also be required to inject further funds to make up the additional losses. Most hedge fund managers maintain extensive risk management practices in order to minimise any losses, but notwithstanding this, the investor should be mindful of the potential that exists to lose more than the capital invested. Hedge funds are therefore usually housed within a Other structures also encountered are structure that limits the investors liability to the capital that they have invested. The most frequently encountered structure is the limited liability partnership. limited liability companies and trusts. Before investing into a hedge fund, the investor should examine the legal structure of the fund in order to understand both the liability and tax consequences of the structure. 1.4.8 Smaller Investment Teams, Outsourced Back Offices

By comparison with most long-only investment teams, the teams managing hedge funds tend to be considerably smaller, usually made up of a lead manager with one or two analysts. By keeping their teams small, they are able to make and implement investment decisions quickly, avoiding the need for structures and committees. portfolios. Larger asset management houses are also increasingly offering hedge fund products. The reasons Non-core functions, such as back office administration, are usually outsourced to specialist administrators allowing the hedge fund managers to focus on managing their

include widening their product range and retaining top investment professionals who may otherwise be attracted to the challenge of managing hedge funds outside of the corporate structure. Institutional hedge funds tend to differ from hedge funds run by specialist hedge fund managers as they tend to operate as variations of the long-only portfolios managed by the same team and do not possess many of the typical characteristics of hedge funds described in this paper. 1.4.9 Limited Liquidity

Most hedge fund managers place restrictions on when they will accept new monies into their funds and when they will allow investors to redeem their investments. Often this is simply that cashflows can only take place at month end. In this way the manager is able to ensure that the portfolio does not have to be adjusted to accommodate cash flows too often and the administration load is reduced.

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Some funds impose more restrictive conditions on their investors, possibly allowing redemptions only at quarter ends rather than monthly. 1.4.10 Risk Management

In order to meet their objective of consistently delivering attractive, positive returns, hedge fund managers need to keep a close eye on the risks inherent in their portfolios at all times. A number of techniques are encountered in practice. Risk management is however as much a mindset as it is a set of tools and techniques. Risk management, although not unique to hedge funds, is such an important part of hedge fund management that it deserves more detailed discussion. Section 1.5 describes many of the more frequently encountered risk management techniques used in the management of risk within hedge funds.

1.5

Risk Management

Hedge fund managers, given their focus on protecting investors capital and delivering positive returns under all market conditions, are required to spend a considerable portion of their energies on identifying and managing the risks to which their portfolios are exposed. The extent of risk management applied For within a fund will vary between funds, both because of the different broad strategies followed by the funds and also as a result of the different attitudes and abilities of the managers managing the funds. example, it is to be expected that the focus on risk management and the risk management tools and techniques applied will be very different between a market neutral equity long/short hedge fund and a trading based hedge fund (these broad strategies are described in Section 1.6). The first measure of investment risk that most students of investment are exposed to is that of portfolio volatility the standard deviation of returns about their mean. This measure of risk assumes that investment risk is symmetrical, both in terms of its occurrence (a return of x% in excess of the mean is as likely as a return of x% below the mean) and in terms of investors utility (investors dislike positive surprises as much has they dislike negative surprises). The asymmetry of investors utility towards positive and negative returns is a key principle behind hedge fund management. Most hedge funds operate on the principle of maximising investors potential profits while minimising investors potential losses. perspective: upside return potential). profits run. Many of the risk management techniques discussed below are also employed within the long-only investment field. The main differences in the world of hedge funds are the level of importance placed on risk management and the focus on risk measurement in absolute return space rather than relative return space. Consequently the risk management tools and techniques applied focus on managing down-side risk without necessarily limiting upside risk (or from the investors A common hedge fund dictum is cut your losses and let your

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1.5.1

Risk Rules These rules

Most hedge funds publish a set of risk rules which they undertake to comply with.

generally cover issues such as the maximum exposure to individual stocks or market sectors, the minimum numbers of counters in their portfolio, the asset classes that may be employed, the permissible net exposure range, and the maximum level of leverage that may be employed. The hedge fund manager will manage his fund so as to remain within these risk rules, but compliance with these risk rules is generally monitored by an outside party not directly involved with the management of the hedge fund portfolio. A hedge funds risk rules generally represent the boundaries of the area within which the hedge fund manager believes he should operate in order to deliver returns at the targeted levels within reasonable risk parameters. At most times the hedge fund manager will operate well within these limits and the manager will apply a number of techniques to manage risk or to monitor risk levels within the portfolio. Risk monitoring tools are an essential part of risk management as they allow the hedge fund manager to measure the levels of risk in the portfolio and therefore to increase or decrease risk levels when to do so is appropriate. 1.5.2 Risk management techniques

Hedge fund managers have a wide arsenal of techniques available to manage risk in their portfolios. Not all techniques are used by all hedge funds and some of the techniques are not applicable to certain strategies. 1.5.2.1 Hedging

The most significant risk management technique employed by hedge funds is that of hedging. Hedging involves adopting offsetting long and short positions in related securities in order to hedge out unwanted, typically systemic, risks in order to retain exposure only to those risks where the hedge fund manager has conviction that his superior insight will result in the achievement of low risk attractive returns. By executing long/short pair trades, the hedge fund manager hedges out exposure to the common return drivers between the long and the short legs of the trade and retains exposure to the relative price relationship between the long and the short sides of the trade. such as interest rate or currency movements. Long/short trades may extend well beyond simple pair trades to basket trades where the hedge fund manager constructs long and short baskets of shares where the common risk exposures of the two baskets hedge each other out, while retaining exposure to the specific risks of the trade. Many hedge fund managers will also hedge out general market risk in a portfolio that would otherwise be net long by being short market index futures or by shorting large capitalisation stocks that have betas to the market of close to 1.0. The common return drivers could be related to market sector, industry, or exposure to particular economic factors,

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1.5.2.2

Diversification:

Experienced asset managers know that even with the best analysis they will not always be right in respect of every investment decision that they make, and that they will in fact be wrong a significant portion of the time. The principle of not putting all ones eggs in one basket is well understood in both the long-only and the hedge fund investment worlds. By limiting exposure to any one trading idea through building a portfolio of diversified trading ideas, hedge fund managers can benefit from the law of large numbers, resulting in greater consistency and lower volatility of returns. high quality trading ideas. 1.5.2.3 Net Exposure Management: The challenge to managers is to balance the benefits of diversification with the need to only enter into

As part of the risk management process, hedge fund managers track their net exposure levels on an ongoing basis. A funds net exposure is the difference between the total long exposure and the total short exposure in the portfolio, expressed as a percentage of investors capital. identifies the portfolios sensitivity to overall market movements. typically measured in both Rand terms and beta-adjusted terms. Some hedge funds attempt to maintain a neutral exposure to markets at all times in order to protect the fund against losses arising from declines in the market as a whole. Other hedge funds are willing to accept a degree of exposure to market direction risk, as they believe that this will allow them to achieve better returns for their investors whilst still protecting investors capital. 1.5.2.4 Gross Exposure Management: When they do not believe that sufficient high In Net exposure For this reason, net exposure is

Hedge fund managers have a particular advantage over their long-only colleagues as they are not compelled to employ all their capital at all times. conviction trading ideas are present at a particular time, they can trim back their exposure. their portfolios.

extreme circumstances, they can take almost all trades off the table and hold predominantly cash in It is certainly common enough practice for hedge fund managers to reduce their exposures when they are less certain about what is happening in the markets. However, when they are more confident about the trades available in the market, they can increase their exposure beyond the capital invested in the fund. Where a hedge fund has a gross exposure level in excess of 100% it is considered to be leveraged. Leverage increases risk in a portfolio. Hedge funds include in their risk rules limitations on the amount of leverage that they may apply. The amount of leverage that is appropriate will depend upon the level of risk in the trades being leveraged. More leverage can be applied to a pair trade involving closely correlated securities than to a pair trade involving securities that have little fundamental association with each other, without increasing the risk to the portfolio as a whole. Leverage, as a single figure, is often not very illustrative to investors as to the level of risk in the portfolio as it does not tell the investor the nature of the trades being leveraged.

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1.5.2.5

Stop Losses:

Almost all hedge fund managers employ stop-loss strategies of one form or another. When entering into a trade, the manager decides what amount of capital he is willing to risk losing on the trade and sets a stop loss at this level. A typical stop-loss strategy would result in the hedge fund manager reviewing any trade that loses 5% from its entry level, with an automatic exit from any strategy that loses 10% of the capital invested in that strategy. Many hedge fund managers set their stop losses based on the percentage of the total portfolio that they are willing to risk on any one trade. A trade that represents a smaller part of the funds total capital will therefore be allowed to fall further before being stopped out than a trade that represents a larger portion of the total fund. Stop losses allow the manager to retreat in order to live to fight another day. Continuing with the metaphor, the manager may lose the odd battle, but his objective must be to win the war. The hedge fund manager knows that he will not always be right about every trade. More importantly, he knows that the rest of the market may not see the situation the way he sees it and the mispricing that he has identified may not correct for some time. Mispriced shares can become more mispriced before they return to In the words of equilibrium; irrational markets can become more irrational before sanity prevails.

John Maynard Keynes The markets can remain irrational longer than you can remain solvent. Stop losses set prior to executing a trade prevent managers from becoming emotionally tied to their trades. Some hedge fund managers also set so-called stop-profit levels when they enter a trade. The

objective is to bank profits when they are earned, rather than to risk giving these back again in the attempt to extract the last cent of profit from the trade. Other managers prefer to rather ratchet up their stop loss levels when their trades become profitable to limit their potential losses from the peak profit position. 1.5.2.6 Value at Risk:

Value at Risk numbers, better known in the industry as VaR, were developed primarily for use in the banking industry in order to measure risk in proprietary trading books where often the banks traders were not allocated actual capital, but rather risk capital. By trading on margin, or through the redeployment of the proceeds of short sales, traders do not necessarily have to be allocated large amounts of the banks capital in order to be able to expose the bank to large potential profits and large potential risks. The calculation methods and the complexity of these calculations have grown dramatically over the past decade as more sophisticated statistical methods are applied to the problem of estimating the risk exposure. In essence, all VaR models look at the past history of the various instruments in the portfolio and attempt to measure the potential losses that the portfolio could achieve over various periods, and at various levels of confidence, by modelling potential future scenarios based on what happened in the past. A typical VaR calculation might suggest that a particular portfolio has a 99% probability of not losing more than R 1 million over a one day period and a 95% probability of not losing more than R500,000 over a week. If the risk in a hedge fund portfolio (the VaR as a proportion of capital employed) is too

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high, the manager can simulate changes to the portfolio in order to determine what should be done to reduce the risk in the portfolio. By the same token, VaR calculations can be used to increase the risk levels in a portfolio when that is deemed appropriate. Many trading operations seek to maintain a constant level of risk in their portfolios over time. VaR calculations are based not only the premise that the best indication of what could happen in the future is reflected in the history of what has happened in the past, but also by taking into account that alternative outcomes of historical experience are possible in the future.

1.6

Hedge Fund Strategies in South Africa

The global hedge fund arena is composed of in excess of 7,000 hedge funds following a wide variety of often esoteric strategies. The local hedge fund market is made up of considerably fewer funds and most of these funds follow much broader strategies. There are difficulties is measuring the number of hedge funds operating in South Africa. Hedge funds are not required to register with any central authority. While some hedge fund performance surveys are published, many hedge funds choose not to participate in these surveys. A number of hedge funds are closed to new investors and are little known beyond their investor base. Some funds which follow hedge fund strategies operate entirely with proprietary capital and do not accept assets from external investors. Some hedge funds are currently part of an incubation process whereby the strategies are first tested with in-house capital before being opened to outside investors once their processes have been tested. There are also debates as to which funds should be considered hedge funds and which not. There are a number of funds which follow hedged equity strategies, which the authors do not classify as hedge funds. partially hedged out with market futures). The range of hedge fund strategies encountered in South Africa is narrower than that encountered globally as a result of the small size of the local investment markets and the consequent small universe of investment instruments. As a result, most hedge funds, particularly those operating in the equity market, follow broad investment mandates which allow the fund managers to exploit opportunities in different areas. This allows the managers not only to allocate capital to different areas of the investment market as the opportunities arise, but it also allows managers to follow a variety of strategies at the same time, reducing dependence on particular market conditions to make money and diversifying the managers source of returns. The authors estimate based on their own database of local hedge funds that there are currently between 45 and 50 hedge funds operating in South Africa that are investable, i.e. that are either open to money from new investors, or are closed to new investors but continue to manage money for their existing investors. For the purposes of classifying local hedge funds the authors have derived four broad hedge fund strategy categories. Each category incorporates strategies that are sufficiently similar to each other to justify being (A hedged equity fund is one where the market risk within a portfolio of long equity positions is fully or

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grouped together, whilst being sufficiently different to the strategies of funds grouped into the other categories to justify being classified separately. The four categories are: Relative Value Strategies Market Neutral Equity Long/Short Strategies Variable Bias Equity Long/Short Strategies Trading Strategies These categories can be broken down into various sub-categories in order to define specific strategies, but the broad categorisation used above should be useful for any investor wanting to invest in a hedge fund as funds falling into each category have important common characteristics which the investor should appreciate before investing in such funds. 1.6.1 Relative Value Strategies

Relative value hedge funds focus on simultaneously taking long and short positions in closely related securities in order to profit from relative pricing discrepancies. The manager takes a long position in the relatively underpriced security and a short position in the relatively overpriced security in order to make a low risk profit from exploiting the inefficiency. Profits will be made when the relative prices revert to their normal relationship and the trade is unwound. Where the long and the short positions are very closely related and the relative price discrepancy is small, the manager will usually apply high multiples of leverage to the trade in order to make the potential reward attractive. Relative value strategies rely on the hedge fund managers ability to identify market inefficiencies before they correct themselves. Timing of the trades is very important. Entering the trade too early will mean lower profits and many trades initially resulting in losses before becoming profitable. Delaying too long will result in profitable opportunities foregone. Hedge fund managers usually use quantitative models to monitor potential trading opportunities. These strategies are relatively low risk strategies where the major risk factors are the level of leverage applied and the independence of the trades executed. 1.6.2 Market Neutral Equity Long/Short Strategies

Market neutral equity long/short hedge funds take both long and short positions in equities with an objective of the funds long exposure and the funds short exposure cancelling each other out. The fund will therefore not be exposed to directional risk from the equity market as a whole. terms and in beta-adjusted terms. In the global arena, the term market neutral applies to funds that seek to maintain a neutral directional exposure at all times. These funds would usually also ensure that the fund has no sector Net exposure (the funds long exposure less its short exposure) will usually be managed in both Rand

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level or market-capitalisation level exposure, and that the fund is therefore exposed only to stockpicking risk. Market neutral equity long/short hedge funds are seen as a subcategory of relative value hedge funds. In the South African market we have found it more useful to classify any equity long/short hedge fund that seeks to maintain a broadly market neutral position as market neutral. For a fund to satisfy our definition of market neutral the fund should strive to limit its directional exposure to less than 10% of the capital employed at least 90% of the time. Market neutral equity long/short hedge funds in South Africa are effectively a sub-set of the variable bias equity long/short hedge funds described in the next section. Given the absence of any meaningful market direction exposure in these funds, they deserve separate classification from the next group of funds. Market neutral equity long/short hedge funds tend to deliver higher returns than relative value hedge funds over time, but with higher levels of volatility. 1.6.3 Variable Bias Equity Long/Short Strategies

Variable bias equity long/short hedge funds are similar to market neutral equity long/short hedge funds with one key difference. Managers of variable bias equity long/short hedge funds are willing to expose their funds to high levels of directional risk from time to time when the managers consider this to be appropriate. These funds generally maintain their net exposure levels between 0% and 100% of the capital invested. Although their mandates generally permit the managers to adopt net short exposure levels, few managers are ever comfortable with meaningful net short levels. These funds tend to deliver more volatile returns than their market neutral cousins, and are exposed to market direction risk. Managers who adopt the variable long bias approach believe that the additional returns that they are able to achieve more than make up for the additional risk. Given the domination of equity long/short hedge fund strategies in South Africa, we explain these funds in greater detail in Chapter 2. 1.6.4 Trading Strategies

Trading hedge funds seek to identify trends in security prices in a variety of markets and to make leveraged bets on the price movements of these securities. The managers use a variety of trading models to identify trading opportunities. Risk management is typically limited to diversification of trading ideas and strong stop loss disciplines. These strategies are the most risky of the strategies operating in South Africa and trading style hedge funds show the greatest volatility of monthly returns of all the strategy categories. Many hedge funds will use multiple asset classes or strategies within the same fund are would normally be classified in terms of the dominant strategy employed.

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2.

EQUITY LONG/SHORT HEDGE FUNDS

The most popular hedge fund strategy in South Africa, both by number of funds and by assets under management, is the equity long/short strategy. Globally, equity long/short funds are increasingly making up a larger portion of the hedge fund landscape both in terms of numbers of funds, and also in terms of assets under management. The reasons for the domination of this strategy in South Africa include: South African hedge funds are effectively limited to investing only within South Africa. The size of the local investment markets is such that the opportunities to follow highly focused strategies are very limited and therefore the available strategy universe is narrower than that encountered globally. Local hedge funds tend to allow themselves greater strategy flexibility in order to be able to able to take advantage of opportunities wherever they identify them and to be able to diversify their exposure to a greater extent. The local equity market provides the widest range of investment opportunities and the greatest source of exploitable inefficiencies. Many local hedge fund managers cut their teeth managing long-only equity portfolios and feel most comfortable adopting an approach most closely resembling investment techniques they have employed before. In this section we provide a generalised description of equity long/short hedge funds. characteristics of these funds can also be found in other hedge fund strategies found locally. Each hedge fund is unique as it depends largely on the abilities of the manager, or team, managing the fund. There are however sufficient common characteristics between different hedge funds operating in the broad equity long/short category to describe a typical equity long/short hedge fund. Managers of equity long/short hedge funds build up portfolios of long and short positions in South African equity counters. At any time their portfolios could consist of some or all of the following categories of trades: independent long positions independent short positions mean reversion arbitrage trades merger arbitrage trades pair or basket trades short term directional trades Many of the

Trading ideas could be generated by a number of sources. The most common sources are: fundamental company analysis technical analysis quantitative models trading models

South African equity long/short hedge funds can generally be divided into those which are willing to take directional risk and those that seek to maintain a broadly neutral exposure to the direction of the market at all times. Those funds that are willing to take directional risk would seldom be net short. Their

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exposures would normally be within the 0% to 100% net long range and these exposures would change over time depending upon the opportunity set identified by the hedge fund manager, or on the managers view on the likely direction of the market as a whole. In Section 1.6 we described such hedge funds as Variable Bias Equity Long/Short Hedge Funds. In Section 1.6 we also described a different classification of equity long/short hedge funds where the fund manager seldom takes on any market direction risk, maintaining a net exposure levels close to zero at all times. We described these hedge funds as Market Neutral Equity Long/Short Hedge Funds. Variable bias equity long/short hedge funds usually arrive at their net exposure levels via a bottom up process. Net exposure levels are arrived at as a result of a portfolio construction process where only high conviction trades are incorporated into the portfolio. At times when equity markets are relatively cheap, the manager is likely to find more high conviction long opportunities than high conviction short opportunities and the portfolio is therefore likely to show a net long bias. When markets are more expensive, the supply of attractive short opportunities will increase and the supply of attractive long opportunities will decrease. Few equity long/short hedge fund managers are ever comfortable positioning their funds net short to any significant degree and therefore in expensive equity markets, variable bias equity hedge funds are most likely to have a neutral net exposure to market direction. Managers are seldom comfortable positioning their funds with a net short exposure as they would then be fighting against the long term upward drift of the equity markets. They would be sailing against the prevailing winds. Some variable bias equity hedge fund managers will also review their net exposure levels using top-down considerations. If the manager is uncomfortable with the funds net exposure based on the trading ideas incorporated in the portfolio, he may alter the exposure using market futures. management. As a result of the balance sheet management processes, variable bias equity hedge funds tend to show positive correlations with rising equity markets and minimal correlations with falling equity markets. The various activities involved in managing a hedge funds net exposure levels are often referred to as balance sheet

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3. 3.1

HEDGE FUND RETURN DATA SERIES Issues Relating to Veracity of Hedge Fund Data Series

In order to conduct meaningful quantitative analysis on the benefits of and the risks associated with investing in hedge funds one requires valid hedge fund return data to work with. There are a number of difficulties in obtaining meaningful data on hedge fund returns to be used for the purposes of analysis. These difficulties have been discussed often in the global context and are equally valid in South Africa. The major issues are: 3.1.1 Voluntary Reporting

There is no central database of hedge fund returns which researchers can access. All databases on South African hedge fund returns are compiled by industry practitioners for, in the main, proprietary purposes. The main compilers of databases are the fund of hedge funds (FoHF) managers and the investment consultants. Many hedge funds prefer to keep a low profile as they are not in the Some are therefore unwilling to participate in published hedge fund Compilers of business of gathering assets.

industry surveys as these are seen as having predominantly a marketing objective.

databases depend largely on their relationships with the hedge fund managers to obtain data series and often the returns supplied to them by individual funds are not permitted to be released publicly. 3.1.2 Unaudited Results

The data received from hedge fund managers is generally unaudited and therefore there are potential issues relating to the veracity of the data. This might relate to the incidence of the returns rather than the cumulative returns, resulting in lower volatility of returns being recorded than was in fact the case. 3.1.3 Survivorship Bias

Over time some hedge funds close down and leave the industry, returning capital to their investors. This is generally more likely to happen to poorly performing hedge funds than it is to better performing funds. The result is that that an index calculation that does not include the funds that closed down during the period would overstate the returns that an investor would have achieved had the investor been invested in an even spread of all the funds operating at those times. A contrary feature reported in many hedge fund data sets is that a number of successful hedge funds stop reporting their return series to data gatherers when they have reached capacity and are no longer looking to attract further assets. Various global studies have suggested that the overstatement of hedge fund returns arising from survivorship bias could be as much as 3% per annum. It is the authors view that neither the survivorship bias factor nor non-submission of return data factor is material in South Africa, in comparison to the other factors that affect how representative any hedge fund industry index calculation is in practice. The few local hedge funds (that would have satisfied the requirement for inclusion into the hedge fund index) that have ceased trading have generally ceased trading for reasons other than the delivery of extremely poor returns.

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3.1.4

Tax and Fees

Most hedge funds report their returns to investors on a gross of taxes and net of fees basis. This is the standard for the comparison of hedge fund return data. Some funds do however report on either a gross-gross basis, or a net-net basis. Where this is the case it is necessary to standardise the data for use in the database.

3.1.5

Backfilling

When new hedge funds are added to the database and their returns are included in the index construction, the index constructor has the choice whether to include the funds history in the index and therefore to recalculate the index with these numbers included, or to only include the funds returns in the index construction prospectively. past index numbers. 3.1.6 Unlisted Securities Well established hedge fund indices would usually only include the returns of newly included funds prospectively in order to avoid the need to restate

The NAVs of hedge funds that have significant exposure to unlisted securities may not reflect the true volatility of the funds underlying investments given the difficulties in pricing unlisted securities where these are not trading in an open market. The values included in portfolios therefore tend to be more stable than the prices that would be achieved should the securities have needed to be sold. This characteristic, while a feature of many global hedge funds, is not material in the local market as few South African hedge funds invest in unlisted securities. 3.1.7 Equal Weighting or Asset Weighting

When constructing hedge fund indices, the index constructor has to decide whether to weight each constituent hedge fund equally, or to weight each hedge fund in the index relative to the size of assets within that fund. Neither approach is ideal. Equally weighting all hedge funds results in larger professionally managed hedge funds being allocated the same weight as small funds, of which there could be many given the low barriers to entry in establishing a hedge fund. Weighting the funds by assets under management could give undue weight to a few funds which would dominate the indices, resulting in indices that are not representative of the industry as a whole. Both equally weighted and asset weighted indices are encountered in practice. Most index constructors set a minimum assets size and a minimum track record before they will include a hedge fund in their index, both to reduce the workload of constructing the index and to make the index more representative of the opportunity set that prospective investors would consider. 3.2 The AHAI South African Hedge Fund Indices

Most constructors of global hedge fund indices construct a wide variety of strategy specific indices and use these to build up overall hedge fund industry indices. This is done in the context of approximately 7000 hedge funds following a wide range of strategies. Given the smaller number of hedge funds currently operating in South Africa and the narrower range of strategies being followed, at this stage the authors have found it useful to construct only six indices of South African hedge fund performance. The AHAI hedge fund indices are described in Appendix 1.

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Six indices are constructed. Four of these relate to the four major strategy groups described in Section 1.6. The fifth index, the AHAI equity hedge fund index, combines the funds making up the two equity hedge fund strategy groups. The final index combines all the strategies into a single index. In the balance of this paper we use the AHAI hedge fund indices to describe the qualities of hedge fund returns. The reader should note that in comparison to global hedge fund indices and to the indices representing the traditional domestic asset classes, the data used to construct the index is sparse. It is however all that is available at the present time. Throughout the paper we use the African Harvest Alternative Investments South African Hedge Fund Index All Strategies (the AHAI Hedge Fund Index or AHAI HFI), which combines all the hedge fund strategies in a single index. This is a very broad brush approach to looking at hedge fund characteristics as the index comprises funds following different strategies with different risk/return profiles. Use of this composite index is sufficient for the purposes of this paper, but investors contemplating investment into hedge funds should also consider whether their investment portfolios can be improved by using hedge funds that follow specific strategies with risk profiles most suited to their investment objectives.

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4.

THE RATIONALE FOR INVESTING IN HEDGE FUNDS

Modern Portfolio Theory suggests that the overall efficiency of a portfolio of assets is determined by three factors: individual asset returns, the volatilities of these returns and the correlation between the returns on these assets. The great contribution made by Modern Portfolio Theory to the challenge of efficient portfolio construction was to show how a diversified portfolio made up of assets with low correlations with each other could potentially have lower risk than any of the assets that make up the portfolio. Diversification is often quoted as being the only free lunch to be had in investments. The extent to which diversification benefits the portfolio depends upon the extent to which assets in the portfolio co-vary with one another over time. The lower the correlation between the assets in a portfolio, the greater will be the diversification benefits to the overall portfolio. Ideally, the portfolio constructor would want to include In otherwise attractive assets which have a negative correlation with other assets in the portfolio. assets which have positive, but low, correlations with other assets in the portfolio. Most usually, when considering the case for including an exposure within a portfolio to a particular asset class one must deal with a risk/return trade-off. Asset classes that exhibit the lowest volatility also have the lowest expected long term returns and asset classes that have the highest expected long term returns also demonstrate the highest volatility. Either the asset class is considered for inclusion as a riskAny asset class that has reduction component or is considered as a return-enhancement component. inclusion into the overall portfolio construction process. A case is generally made for investing in hedge funds from all three of these perspectives, i.e. as a diversifying asset with potentially attractive long term returns at a reasonable level of volatility. When considering whether hedge funds have a role to play in an investors overall investment portfolio, one needs to examine each of these factors: Returns Volatility of returns Correlation of returns with those of other major asset classes Although arguments can be made both for and against treating hedge funds as a separate asset class, for the purpose of this analysis hedge funds have been treated as a separate asset class. African Hedge Fund Indices, described in Section 3.2 and in Appendix 1. 4.1 Returns The analysis is conducted over the period commencing 1 January 1999, as this is the start date for the AHAI South

practice these are difficult to come by. Attractive diversification benefits can still be achieved by including

diversification benefits and makes a case for any one of these two reasons should be considered for

Figure 4.1 shows the cumulative returns earned by South African hedge funds as reflected by the AHAI Hedge Fund Index, compared to those on the FTSE/JSE All Share Index and the BESA All Bond Index. The graph also shows the monthly returns achieved on the AHAI HFI as indicated by the bar chart.

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450.0 400.0 350.0 300.0

M o nthly Returns - A HA I Hedge Fund Index Cumulative Gro wth - A HA I Hedge Fund Index Cumulative Gro wth - FTSE/JSE A ll Share Index Cumulative Gro wth - B ESA All B o nd Index

22.0 17.0 12.0

250.0 200.0 150.0 100.0 50.0 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Mar-04 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Jun-04
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7.0 2.0 -3.0 -8.0

Figure 4.1: Monthly returns for the hedge fund index, cumulative returns of the hedge fund index, the ALSI and the ALBI

Over the period under consideration the hedge fund index performed very favourably when compared to the performances achieved in the equity and bond markets. The hedge fund index showed very few negative months, and on average these negative returns were relatively small when compared to the average monthly return for this series. The average return earned by the hedge funds included in the index was 28.3% per annum over the 66 month period from 1 January 1999 to 30 June 2004. Table 4.1 compares the returns achieved over the same period on domestic equities, as represented by the FTSE/JSE All Share Index, on domestic fixed income, as represented by the BESA All Bond Index, and on domestic cash, as represented by the Alexander Forbes STeFI Composite Index, as well as the average inflation rate, as represented by CPIX. FTSE/JSE ALSI 15.4% p.a. BESA ALBI 18.0% p.a. STeFI 11.7% p.a. AHAI HFI 28.3% p.a. CPIX 7.3% p.a.

Table 4.1: Annualised returns for equities, bonds, cash and hedge funds and annualised inflation (January 1999 to June 2004)

Given that the period under consideration is relatively short, it is useful to consider some of the major factors that characterised the period, in order to place these numbers in some context: 1. The equity market was characterised by three macro cycles during this period. The first cycle can be described as a bull market and spanned the period January 1999 to May 2002. Over this period the equity market returned 126.4% (27.0% annualised). This period was followed by bear market which lasted until April 2003 which saw the market lose 30.4% of its value.

The third phase, which can be characterised as an equity market correction ended in June 2004 with a return of 39.3%. 2. The local fixed income market was dominated by a bull market over the entire period as a result of falling inflation and falling interest rates that resulted in capital gains. This asset class returned 148.4% (18.3% annualised) over the period. 3. The hedge fund industry was initially characterised by a small number of funds operating in a market with plentiful opportunities. It may be that this overstates the returns that investors can expect from hedge funds into the future. Table 4.2 provides the comparative returns for the equity market, fixed income market, cash and hedge funds during the various equity market cycles described above.

Equity Cycle Bull Bear Bull

Period Jan 99 - May 02 Jun 02 - Apr 03 May 03 - Jun 04

Months 41 11 14

Equity Return 126.4% -30.4% 39.3%

Bond Return 87.9% 18.8% 11.3%

Cash Return 47.2% 11.7% 11.9%

Hedge Funds Return 168.3% 14.7% 28.1 %

Table 4.2: Comparative returns for equities, bonds, cash and hedge funds over equity bull and bear market cycles (January 1999 to June 2004)

Hedge funds performed very well during the various phases of the equity market under consideration. Hedge funds performance kept up with and exceeded the equity market performance during the period January 1999 to May 2002, but this period includes the early period when very few hedge funds operated in the domestic market and opportunities for hedge funds were particularly plentiful. Although this performance is exciting, it is probably too high to base any reasonable expectations of the future performance of this asset class. The bear phase and the following recovery shown in the table above demonstrate the strongest part of the performance argument. During the bear market when the JSE lost almost a third of its value, hedge funds managed to produce positive returns. The hedge fund index returned 15.5% over this 11 month period. When equity markets recovered and showed strong returns hedge fund returns lagged those of equities, but at otherwise attractive levels. In our opinion, the second and third phases shown above are more representative of normal hedge fund performance behaviour going forward. Over these periods, returns were significantly positive, but lagged those of the equity market by a margin during a very strong equity bull market, whilst returns were positive and comfortably above cash during a severe equity bear market, locking in value and preserving capital. Whilst the period under consideration above is too short to draw meaningful conclusions from about long term future expected performance, it is worth noting that the real returns earned on equities, bonds and cash over the period were fairly consistent with those observed over longer periods. Credible bond return figures date back to the introduction of the All Bond Index in 1986. Over a number of cycles since 1986 bonds have delivered higher returns than equities. This conflicts with the traditional finance theory where the equity risk premium is expected to result in equities achieving higher returns over longer periods.

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What one can conclude however is that hedge fund returns would have to reduce significantly from the levels experienced in recent years to no longer compare favourably with the returns of either equities or bonds. Hedge fund returns essentially comprise of three components; cash returns, costs and alpha. Hedge fund returns are therefore particularly sensitive to the ability of hedge fund managers to add alpha. For hedge fund returns to reduce significantly in the future, either the opportunities to add alpha need to be fewer relative to the capital employed, or the skills of the managers in exploiting these opportunities must reduce on average. From what is shown above, one can comfortably conclude: Over the 66 months review period hedge funds produced high returns in absolute terms and attractive real returns, significantly better than those produced by the traditional asset classes. These hedge fund returns were also attractive relative to the returns achieved on the traditional asset classes over the longer term. While one can not be certain that hedge funds will be able to repeat such phenomenal performance into the future, they will have to disappoint by a considerable margin relative to what they have managed to produce to date before they are no longer competitive in the return dimension relative to equities, bonds and cash. We have also observed some diversification benefits between hedge funds and other asset classes, in particular equities. 4.2 Volatility of returns

When constructing a portfolio of assets one normally separates the risk and return dimensions to keep the problem manageable. An analyst will independently attempt to determine the potential return on each asset, and then as a separate exercise attempt to determine the likely risk of those returns. There are multiple ways of trying to estimate the likely future risk of an asset class. The most widely used method simply determines the historical volatility of periodical returns (normally monthly) for each asset class as a basis for the risk estimate. Slightly more complex methods recognise the possibility that risk is not symmetrical and treat the risk estimates as a two-sided distributional problem, i.e. in terms of downside and upside risks relative to the mean return. Even more complex methods aim to use historical realised returns and volatilities to build complex statistical models to predict the likely risks associated with the various asset classes considered for inclusion in the portfolio. Clearly there is no one correct method to determine the risks associated with an asset class for portfolio construction purposes, and we believe that the simplest still provides one with valuable insights. In this section we will merely aim to show that, based on the historical distribution of monthly hedge fund returns, there is a case for the inclusion of hedge funds into a portfolio of traditional assets under the risk reduction argument. The most commonly used measure of investment risk is the volatility of periodical returns. The volatility measure is usually but not always estimated from historical monthly or weekly returns and determined by

30

the series standard deviation or variance. Table 4.3 compares the volatility of monthly returns delivered by hedge funds over the 66 months from 1 January 1999 with the volatilities of monthly returns delivered by equities, bonds and cash over the same period. The upside and downside deviations for each asset class are also shown.

Measure Standard Deviation Upside Deviation Downside Deviation

FTSE/JSE ALSI 20.5% p.a. 13.0% p.a. 11.0% p.a.

BESA ALBI 7.0% p.a. 5.4% p.a. 4.1% p.a.

STeFI 0.7% p.a. 0.7% p.a. N/A

AHAI HFI 6.3% p.a. 5.9% p.a. 1.1% p.a.

Table 4.3: Risk measures for equities, bonds, cash and hedge funds (January 1999 to June 2004)

This analysis indicates that hedge fund returns exhibit low levels of volatility, closer to those of bonds, than to those of equity. The upside and downside deviation measures estimate the volatility of positive and negative returns respectively, and they do not relate directly to the total volatility measure (standard deviation). These measures are however directly comparable between asset classes. The analysis shows that hedge funds show a skewed risk profile in favour of positive returns. The hedge fund returns have much larger upside deviations than downside deviations. Having made this observation, it is worth mentioning is that since the hedge fund index exhibits so few negative returns, the estimation error involved with the calculation of the downside measure is potentially very high. The bond asset class also presented a very favourable upside versus downside risk profile. It is important to note that over the period under consideration the bond market was characterised by a very strong bull market as a result of a falling inflation and interest rates environment which would serve to improve these statistics in favour of positive returns. These favourable upside deviation statistics in respect of bonds are unlikely to be as favourable in future, whereas there is no such a reason to believe that hedge funds will not be able to retain the skewed performance behaviour going forward. Figure 4.2 shows the best-to-worst monthly return range over the period under consideration. It illustrates that hedge funds experienced a narrower range of monthly returns than either equities or bonds. Hedge fund return upsides are capped when compared to equity, but their worst months are only slightly negative and substantially better than those of both the equity or bond indices.

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Best to Worst Monthly Return Range 20.0 15.0 10.0 5.0 -5.0 -10.0 -15.0

AHAI HFI

ALSI

Figure 4.2: Range of monthly returns for hedge funds, equities and bonds (January 1999 to June 2004)

Figure 4.3 shows the return distribution of monthly returns of the AHAI Hedge Fund Index compared with that of the FTSE/JSE All Share Index. The chart indicates the skewed return nature of hedge fund returns, as well as the more stable nature of their returns as compared to those of the equity market.

Return Distributions: AHAI HFI & ALSI 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0 to 3 3 to 6 6 to 9 -Inf to -12 -9 to -6 -6 to -3 -12 to -9 9 to 12 -3 to 0 12 to +Inf AHAI HFI ALSI

Figure 4.3: Distribution of monthly returns for equities and hedge funds (January 1999 to June 2004)

Figure 4.4 shows the rolling 12 month monthly volatilities of hedge fund returns, as well as of equity and bond returns, over the term under consideration. The chart clearly indicates that hedge fund returns experienced levels of volatility which were much closer to those of the bond market than those of the equity market, and that these levels of volatility were fairly stable. Having said that it can also be noted that the volatility of the hedge fund index returns can be seen to reduce over time, a factor that can be attributed to the inclusion of a greater number of hedge funds in the index, a feature discussed further in Section 6.

ALBI

32

Rolling 12 Month Volatilities 30.0%


A HA I HFI JSE A ll Share Index B ESA A ll B o nd Index

25.0%

20.0%

15.0%

10.0%

5.0%

0.0% Oct-00 Oct-01 Oct-02 Feb-00 Feb-01 Feb-02 Feb-03 Oct-03 Feb-04 Jun-00 Jun-01 Jun-02 Jun-03 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Apr-00 Apr-01 Apr-02 Apr-03 Aug-00 Aug-01 Aug-02 Aug-03 Apr-04 Jun-04

Figure 4.4: Rolling 12 month volatilities for equities, bonds and hedge funds (January 1999 to June 2004)

Hedge fund investors generally consider a wider range of risk measures than simply the ones described above, in particular many more measures that focus on downside risk. A number of these are considered in Section 5.1. From what we have seen in Section 4.2 one can draw the following conclusions: Hedge funds experienced low levels of total monthly volatility over the review period, which were closer in magnitude to those experienced in respect of bonds rather than those experienced in respect of equities. The realised volatilities of hedge fund returns were fairly stable over the period under consideration. This implies that one can make a reasonable estimate of the future investment risks for portfolio modelling and construction purposes. The investment risks within hedge funds are heavily skewed toward positive returns, whereas the upside and downside volatility measures are more balanced within both equities and bonds. The conclusion one can draw from this is that hedge fund managers are on average successful in limiting downside risk in favour of upside risk. Another implication of this skewed nature of hedge fund returns are that a pure Modern Portfolio Theory portfolio construction model (such as the Markowitz model) based on expected returns, volatilities and correlations would penalise hedge funds since the total volatility measure used by the model would anticipate equal weights of both positive and negative returns. Up to this point of the analysis it certainly seems that a case can be made for the inclusion of hedge funds from both a risk reduction perspective, as well as a performance enhancement perspective.

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4.3

Excess Negative Kurtosis

Many studies of the global hedge fund industry have identified both positive skewness and negative excess kurtosis in the distribution of hedge fund returns. It is not the intention of this paper to go into a detailed explanation of kurtosis, other than to mention that distributions that demonstrate negative excess kurtosis have the ability to deliver infrequent, large (relative to their mean) negative surprises. Excess kurtosis exists in the hedge fund universe because of predominantly two reasons: Hedge funds utilise leverage. When a fund does not manage its risk properly, substantial losses can be incurred when unexpected market events occur. Unlike long-only portfolios, hedge funds can lose their entire capital and more. Such events can happen, resulting in unexpected large negative returns. Some hedge funds strategies exhibit non-linear payoff profiles, similar to those of options. To illustrate this non-linearity of some hedge fund strategies, consider merger arbitrage as an example. Most often these hedge funds would purchase the shares of a company where the merger with another company has been announced to the market, but before the competition authorities have granted the two companies approval for the merger. Hedge fund managers would know the exact price the acquiring company is going to pay if the deal proceeds, and as a result they can normally realise a small return with a relatively high degree of certainty. The potential returns from such a position are small, but given its lack of market risk, hedge funds often gear these positions substantially. Every so often one of these mergers fails for some or other reason. The natural market reaction is almost always negative following such an event, which leads to substantial losses for the hedge fund. This strategy is similar to the naked selling of options. Small premiums are realised on a regular and consistent basis, but when an event occurs, the option seller normally incurs a material loss. We have found no evidence in the data representing the South African hedge fund industry of excess negative kurtosis, but by definition, we are referring here to rare events. Furthermore, most of the funds in our index are long/short equity managers and few utilise strategies which can be considered non-linear and option-like as explained above. That no evidence is found in the data, could just as easily mean that the rare event has not shown itself yet, as much as it could mean that the potential does not exist. The potential for large negative surprises will differ between hedge fund strategies. Being mindful of the potential for large losses should be one of the considerations of any investor selecting individual hedge funds or compiling a portfolio of hedge funds.

4.4

Risk/Return Trade-off

The introduction to this section suggested that an asset should be considered for inclusion in a diversified portfolio of assets based on either a risk reduction or a return enhancement argument, or both. The case for hedge funds up to this point of the analysis is based on both premises. When developing investment strategies, most investors are generally concerned with both risk and return. It is thus useful to consider various approaches to simultaneously examining both aspects of a strategy.

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4.4.1

Risk and Return Scatterplots

The most common approach to depicting both risk and return is a simple risk and return scatterplot, where each asset classs average annual return is shown on the vertical axis and the average monthly volatility is shown on the horizontal axis. 2004. Figure 4.5 shows a scatterplot of the risk and return experience of domestic equities, bonds, cash and hedge funds over the 66 months ending 30 June

Total Risk and Return Scatterplot 30.0 25.0 Average Return 20.0
A LB I A HA I HFI

15.0 10.0
CP IX

A LSI

5.0 10.0 15.0 20.0 25.0


A LSI

5.0
A HA I HFI

Total Risk
Figure 4.5: Risk and return scatterplot for equities, bonds and hedge funds (January 1999 to June 2004)

Figure 4.6 shows the same information but using the downside risk measure instead of the total risk measure.

Dow nside Risk and Return Scatterplot 30.0 25.0 Average Return 20.0
A LB I

15.0 10.0
CP IX

5.0 0 2 4 6 8 10 Dow nside Risk


Figure 4.6: Downside risk and return scatterplot for equities, bonds and hedge funds (January 1999 to June 2004)

12

35

Both charts reinforce in simple graphical terms the conclusions drawn in the analyses in Sections 4.1 and 4.2; that hedge funds performed very well from both the risk and return perspectives and that, in fact, hedge funds performed even better when the downside risk measure was used instead of the total risk measure. 4.4.2 Consistency of Returns

Figure 4.7 shows rolling 12 month returns for equities, bonds and hedge funds over the same 66 month period. This diagram allows us to assess the consistency of returns derived from each of the asset classes, as well as illustrating the best and worst 12 month returns experienced over the period.

Hedge fund returns were characterized by a period of extremely high returns over the first few months of the period. Thereafter the returns stabilized. Hedge fund returns were clearly more stable over the period than the returns earned on either equities or bonds.

70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% Mar-00 Mar-01

Rolling 12 month Returns

Rolling 12M AHAI HFI Rolling 12M ALSI Rolling 12M ALBI Mar-02 Mar-03 Mar-04 Jun-00 Jun-01 Jun-02 Jun-03 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Sep-00 Sep-01 Sep-02 Sep-03 Jun-04
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Figure 4.7: Rolling 12 month returns for equities, bonds and hedge funds (January 1999 to June 2004)

The worst 12 month returns achieved by each of the asset classes over the period are shown in Table 4.5. It is notable that the worst 12 month return for hedge funds was greater than the worst 12 month return for cash.

FTSE/JSE ALSI -29.0%

BESA ALBI 5.7%

STeFI 9.5%

AHAI HFI 14.6%

Table 4.5: Worst 12 month returns for equities, bonds, cash and hedge funds (January 1999 to June 2004)

Figure 4.8 shows rolling 12 month returns plotted against rolling 12 month monthly volatilities for hedge funds over the analysis period, with the equity market used as a comparative measure. These representations, commonly known as snail trails, allow us to assess the consistency of both returns and short term volatility over time.

AHAI HFI & ALSI Snail Trails 70% 60% 50% 40% 12 Month Return 30% 20% 10% 0% -10% -20% -30% -40% 0% 5% 10% 15% 20% 12 Month Risk 25% 30%
JSE A ll Share Index A HA I HFI

Figure 4.8: 12 month risk and return snail trails for equities and hedge funds (January 1999 to June 2004)

The snail trail analysis confirms the conclusions drawn from Tables 4.1 and 4.5 together with Figure 4.6. That is that over the period hedge funds consistently achieved their returns with lower levels of short term volatility than equities, that the worst 12 month return earned by hedge funds was considerably higher than the worst 12 month return earned on equities, and that the average annual returns earned on hedge funds comfortably exceeded the average annual returns earned on equities. 4.5 Correlations between Hedge Fund Returns and Those of Other Asset Classes

Modern Portfolio Theory provides us with a mathematical proof of the diversification benefits that can be achieved by combining assets in a portfolio whose returns are not perfectly correlated with each other. The expected returns on the portfolio are simply a weighted average of the expected returns on each of the asset classes used in the portfolio.

37

E ( RP ) = wi E ( Ri )
i

where Portfolio Return Expected Portfolio Return The weight of asset i in the portfolio The expected return on asset i in the portfolio.

RP E ( RP )
wi E ( Ri )

The expected variance of the portfolio is determined using the formula

Var ( RP ) = wi2Var ( Ri ) +
i= j i

w w
i j ij i i i j

RP
Var ( RP )

Portfolio Return The variance of portfolio returns The variance of return of asset i The Standard deviation of the returns of asset i The correlation between asset i and j

Var ( Ri )

i
ij

The overall risk reduction achieved by adding additional assets into a portfolio is driven by the second part of the expected variance formula for the overall portfolio. The first half of this equation states that the variance (or volatility in its square form) is equal to the squared weighted average of individual asset variances. The second part states that over and above the weighted average of individual asset variances, the portfolio volatility is also directly influenced by the co-variation between assets, i.e. the co-variance or correlation between assets. All else being equal, one should be able to lower overall portfolio volatility by including assets with low volatility and low correlation with other assets in the portfolio. In the introductory paragraph, we stated that hedge fund should display low levels of correlation with traditional asset classes since they have been constructed as such. Table 4.6 shows the historical correlations between the various asset classes for the period under consideration. The addition of bonds, cash or hedge funds to a portfolio of equities will reduce the overall volatility of the portfolio both as a result of lowering the average volatility of the components of the portfolio, as well as a result of the various components having low correlations with each other.

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Correlation Equity Bonds Cash Hedge Funds

Equity 100.0

Bonds 4.2 100.0

Cash 9.1 26.8 100.0

Hedge 24.6 16.6 45.2 100.0

Table 4.6: Correlations between monthly returns: equities, bonds, cash and hedge funds (January 1999 to June 2004)

Correlation calculations reflect the average correlation between the two asset classes over the period of observation. Correlations between asset classes are however not stable. As low levels of correlation between asset classes provide diversification benefits to investors, investors should also examine whether these correlation benefits persist during extreme conditions. For example, if an investor were to hold an exposure to hedge funds in his portfolio to diversify the risk inherent in his exposure to equities in the portfolio, he would want to know that the correlation between hedge fund returns and equity returns did not increase when equity markets entered crisis periods. Figure 4.9 shows the returns achieved on hedge funds as reflected by the AHAI All Hedge Fund Index over the worst equity distress months during our period of analysis.

Equity Distress Month Returns 10.0 6.1

2.2

5.0

2.1

1.5

4.2

-1.2 -1.7

-5.0

0.3

0.9

-9.3

-9.3

-10.0

-8.0

-15.0 Month of May-99 Month of Mar-01 Month of Sep-01

-13.1 Month of Jul-02

Month of Mar-03

-7.9

0.9

AHAI HFI ALSI ALBI

Figure 4.9: Monthly returns for hedge funds, equities and bonds in equity distress months

This analysis shows that in all five of these worst equity months hedge funds returned positive returns. Bonds achieved positive returns in three of these five months and negative returns in two. Overall, one can conclude from this analysis that the diversification benefits of investing in both hedge funds and equities are retained during periods of equity distress, when these benefits are most required.

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One can also assess the correlation between equity and hedge fund returns by preparing a simple scatterplot of returns. Figure 4.10 shows for each month of the analysis period the return achieved on equities on the horizontal axis and the return achieved on hedge funds on the vertical axis.

AHAI HFI Sensitivity Relative to the Equity Market 15.0

10.0

Fund Return

5.0

-5.0

-10.0 y = 0.08 x + 1.98 R2 = 0.06 -15.0 -10.0 -5.0 10.0 15.0 5.0 -

-15.0 Equity Market Return

Figure 4.10: Correlation of monthly hedge fund returns with equity returns (January 1999 to June 2004)

Using linear regression to produce a best fit line one can show that over this period hedge funds showed a beta to the equity market of 0.08. From the investors perspective this suggests that very little of the returns achieved by hedge funds can be explained by returns achieved on equities. Given that the majority of hedge funds in the AHAI Hedge Fund Index operate predominantly in the local equity market, and that a number of these equity long/short hedge funds demonstrate some positive directional exposure to the equity market, this low beta is possibly surprising. 4.6 Summary of the triple rationale for investing in hedge funds:

The various quantitative analyses shown above have used a number of return and risk statistics to illustrate that the actual realised historical returns of hedge funds in South Africa made a very compelling case for hedge funds as an investment, either on a stand-alone basis when compared to other asset classes, or as part of an balanced investment portfolio that includes exposure to domestic equity, bonds and cash. The reasons were three-fold. Firstly, hedge funds demonstrated very high levels of return over the We recognised that the

period, both in absolute terms and relative to the other major asset classes.

period was very favourable for hedge funds, and that the period was a particularly volatile one for equities. We also looked at the realised real returns of the other major asset classes over longer periods, periods for which comparable hedge fund return numbers are not available. It was shown that hedge funds would have to disappoint by a very significant margin in the future before they are no longer competitive relative to equities, bonds or cash asset on the basis of expected returns. This confirms the findings of numerous studies in the global markets.

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Secondly, we considered the volatility of hedge fund returns as well as other measures of risk focusing on downside risk. Hedge funds demonstrated volatility levels equivalent to those experienced by bonds. However, when one focused on downside risk measures, hedge funds demonstrated lower downside risk than both equities and bonds, consistent with hedge fund managers focus on downside risk management. Thirdly, hedge fund returns showed low levels of correlation with equity and bond returns. The higher

level of correlation with cash was a function of the success of the hedge fund index in generating consistent positive returns. These lower levels of correlation make a compelling case for the inclusion of hedge funds into a balanced portfolio since the lower level of correlation should bring substantial diversification benefits. Finally, the sensitivity of hedge fund returns to both positive and negative equity markets was tested, and their betas were found to be negligible in negative equity markets, but slightly positive during positive equity markets. This means that the inclusion of hedge funds in balanced portfolios would make the overall portfolios less sensitive to equity market moves (another way of seeing the benefits of risk reduction), whilst simultaneously compensating the portfolios with market insensitive alpha-based returns. Explained another way, the inclusion of hedge funds in a balanced portfolio will have the effect of lowering overall portfolio risk by virtue of replacing systematic risks (risk such as equity market sentiment risk or interest and yield curve risks) with market independent unsystematic risks, or alpha risks. 4.7 Efficient Frontiers

Since hedge funds satisfy a triple rationale for their inclusion in a balanced portfolio, the next question should be what weight should be assigned to hedge funds in a balanced portfolio of assets. In this section we will explore some basic portfolio construction tools to help answer this question, but the trained eye will immediately foresee the inevitable. The actual realised returns and risks of hedge funds have been so superior relative to the other asset classes and the correlations with the returns of the other asset classes have been so low, that they would dominate any efficient frontier based analysis. It is however still worthwhile to construct such a portfolio in order to understand the sensitivities and issues involved by including hedge funds in a balanced portfolio, albeit purely from a quantitative perspective. The section following will be more pragmatic, by attempting to construct a balanced portfolio from a set of forward looking expected returns and risk parameters to see whether the quantitatively suggested levels of hedge fund investment yield a more meaningful answer. The efficient frontier is a name given to the mathematic series of risk and return combinations that would yield an investor the highest Sharpe ratio for a pre-specified set of asset class expected returns, risks and correlations. No other point in risk-return space is more efficient (has a higher Sharpe ratio) than those on the efficient frontier. It is the highest level of expected return for a given level of total risk, or alternatively, the lowest level of total risk for a given level of expected return.

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4.7.1

Using historical returns

For the construction of our historical efficient frontier, we used the following set of inputs (as derived from historical return series):

Equity Bonds Cash Hedge Funds

Risk 20.5 7.0 0.7 6.3

Real Return 9.4 9.9 4.1 18.3

Equity Bonds Cash Hedge Funds

Equity 100.0

Bonds 4.2 100.0

Cash 9.1 26.8 100.0

Hedge Funds 24.6 16.6 45.2 100.0

Table 4.7: Inputs into efficient frontier model based on observed returns, risks and correlations for equities, bonds, cash and hedge funds (January 1999 to June 2004)

Figure 4.11 shows the risk and return scatter plot with the efficient frontier super-imposed over the risk and return plot.

20.0% 18.0% 16.0% 14.0% Return 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Cash

Efficient Frontier Modeling


AHAI HFI

Bonds

Equity

10.0%

15.0%

20.0%

Risk

Figure 4.11: Efficient frontier based on observed experience (January 1999 to June 2004)

Figure 4.12 shows that the optimal allocation from this efficient frontier optimisation contained only combinations of cash and hedge funds. The reason for this should be clear. Hedge funds significantly

25.0%

0.0%

5.0%

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outperformed both equities and bonds in risk and return space given the set of historical parameters currently considered.

Optimal Allocation
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 4.10% 7.00% 8.00% 9.00% 10.00% 11.00% 12.00% 13.00% 14.00% 15.00% 16.00% 17.00% 17.50% 18.00% 18.30%

Hedge Funds Cash Bonds Equity

Total Risk
Figure 4.12: June 2004) Optimised allocation to different asset classes for various levels of risk (January 1999 to

The following optimisation placed a constraint on the optimisation procedure, in that the weight allocation to hedge funds was limited to a maximum of 20%. All other asset classes were left unconstrained. Figure 4.13 shows the efficient frontier under these constraints, and figure 4.14 shows the optimal allocations for different levels of total risk.

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20.0% 18.0% 16.0% 14.0% Return 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Cash

Efficient Frontier Modeling


AHAI HFI

Bonds

Equity

10.0%

15.0%

20.0%

Risk
Figure 4.13: Efficient frontier based on observed experience, with hedge fund allocation constrained to 20% (January 1999 to June 2004)

Optimal Allocation
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 4.11% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 11.00% 11.50%

Total Risk

Figure 4.14: Optimised allocation to different asset classes for various levels of risk, hedge funds constrained to 20% (January 1999 to June 2004)

25.0%

0.0%

5.0%

Hedge Funds Cash Bonds Equity

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4.7.2

Using future expected returns

Efficient frontiers constructed using historical, observed returns and volatilities are only useful if we expect the future to replicate the past. This will seldom be the case and therefore it is more useful to model efficient frontiers using best estimates of what one expects to happen in the future. In this section we create efficient frontiers based on expected long term future real return and volatility assumptions, whilst retaining the correlation estimates used in the previous section. following set of assumptions: Asset Class Equity Bonds Cash Hedge Funds Risk 20.00 7.00 0.70 7.00 Real Return 7.00 5.00 3.00 7.00 We use the

Table 4.8: Inputs into efficient frontier model based on assumed future returns, risks and correlations for equities, bonds, cash and hedge funds

In these assumptions we argue that, conservatively, one can expect hedge funds to deliver levels of real returns in line with equities, but with bond-like levels of volatility. Given these assumptions, we create an efficient frontier with the constraint that the maximum investment that a fund can make in hedge funds is 20%. Figure 4.15 provides the efficient frontier under these assumptions and Figure 4.16 the optimal allocations for various levels of risk.

8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Cash

Efficient Frontier Modeling


AHAI HFI Equity

Return

Bonds

10.0%

15.0%

20.0%

Risk
Figure 4.15: Efficient frontier based on assumed future experience, with hedge fund allocation constrained to 20%

25.0%

0.0%

5.0%

45

Optimal Allocation
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%

Hedge Funds Cash Bonds Equity

Total Risk
Figure 4.16: Optimised allocation to different asset classes for various levels of risk, hedge funds constrained to 20%

The simple assumption that hedge funds will achieve equity-like returns with bond-like volatility immediately positions hedge funds as more attractive than either equities or bonds in the risk/return space, favouring a significant allocation to hedge funds in any efficient portfolio. Only by constraining the allocation to hedge funds to a maximum of 20% does inclusion of the other asset classes become justified to a meaningful degree. Assuming lower real returns or higher levels of volatility from hedge funds would significantly alter the results of this exercise.

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5.

RISK ANALYSIS

Prospective investors into a particular hedge fund will want to gain an understanding of the risks associated with investing in that fund. In order to achieve full understanding the investor needs to spend time with the hedge fund manager understanding the strategies followed by the fund and the risk management techniques applied by the manager in practice (qualitative analysis), on the one hand, and to examine the funds performance history to examine whether this risk management was effective in practice (quantitative analysis). We have discussed some of the risk management techniques employed by hedge fund managers in Section 1.5. In this section we describe some of the quantitative techniques that an investor can employ to examine the effectiveness of the funds risk management in practice. To understand the risks associated with a particular hedge fund it is important to carry out both the qualitative and the quantitative analyses. Conducting only the qualitative analysis might mean that the investor could be swayed by the manager providing text book answers to questions posed, while in practice the fund assumes much higher levels of risk than presented. If, on the other hand, the investor bases his assessment of a hedge funds risk profile simply on that funds performance history, it may be possible for the investor to get too positive a picture of the funds risk profile. Consider a hedge fund that follows a simple strategy of selling deep out of the money call options and deep out of the money put options. If the fund operates in an environment where equity markets are relatively stable and the options that the fund has sold are never exercised, the fund will earn a return equivalent to the cash return plus the premiums received from writing the options. The funds returns will be above the risk free rate and the volatility of these returns will be very low. Based on this return series a very convincing argument can be made for investing in the fund. What the potential investor is not aware of is the risk that the fund is exposed to, but which has not been realised in practice. What an investor should consider when analysing a hedge fund is the alternative scenario histories that the fund may have experienced, as well as the history that the fund actually experienced. Only by doing this can the true risk profile of the hedge fund be understood. In this section we consider various quantitative tools for analysing the success of a particular hedge fund manager in managing risk over time. There are a wide variety of analyses that can be conducted and it is the authors opinion that no single measure is sufficiently illustrative used on its own and that a prospective investor into a hedge fund is best served by conducting as wide a range of different analyses as possible in order to build up a comprehensive view of the capabilities of the hedge fund manager in managing the risks in the fund and of the residual risks inherent in the fund. As a result, final judgements regarding the risk management capabilities of the hedge fund manager and the risk characteristics of the hedge fund must be judgemental, rather than the outcome of an exercise that distils the available information into one or two simple to use summary figures. We describe below a number of the more common analyses used by hedge fund investors, and while these analyses are typically used to illustrate the risk characteristics of individual hedge funds we will

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demonstrate the different analyses by analysing the returns of the AHAI Hedge Fund Index as well as the FTSE/ JSE All Share Index, which is used as a comparative measure. All analyses are conducted over the period from 1 January 1999 to 30 June 2004, the period for which we have hedge fund index data. The risk characteristics of the individual hedge funds included in the Hedge Fund Index will be greater than reflected by the index itself due to the diversification benefits inherent in the index composite. The same is, of course, true for equities where the risk characteristics of the individual equities included in the index will be greater than those reflected by the FTSE/JSE All Share Index. 5.1 Volatility As previously discussed, variance

The first measure of risk used is the variance of monthly returns.

measures the standard deviation of returns around the mean. As such it is a measure of total risk and does not differentiate between upside risk and downside risk. Despite its shortcomings as a measure of risk, it is widely used as a simple measure of historical portfolio risk.

FTSE/JSE ALSI AHAI HFI

20.5% 6.3%

5.2

Downside Risk

Investors naturally wish to limit downside surprises, whilst they are generally quite happy to benefit from upside surprises, particularly if they are satisfied that the risks in their investment portfolio are not symmetric. As hedge fund managers attempt, through their investment and risk management processes, to achieve an asymmetric distribution of returns it is thus more appropriate to measure the downside risk only. FTSE/JSE ALSI AHAI HFI 11.0% 1.1%

Hedge funds experienced a total risk level 0.31 times that of equities over the period, but a down-side risk level 0.10 times that of equities. Analysts have sought to consolidate risk and return numbers into a single factor in order to compare the risk-adjusted returns of portfolios. Sharpe Ratio and the Sortino Ratio. 5.3 Sharpe Ratio The two most common measures of risk adjusted returns are the

The Sharpe ratio, calculates the ratio of units of return in excess of the risk-free rate of return achieved for each unit of risk experienced, as measured by the variance of the portfolios total returns. The Sharpe ratio is a useful measure for comparing the risk-adjusted returns of portfolios that demonstrate symmetrical risk characteristics.

FTSE/JSE ALSI AHAI HFI

0.3 2.2

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5.4

Sortino Ratio

The Sortino ratio is very similar to the Sharpe ratio, other than the denominator used is downside risk, rather than total risk. Because hedge funds tend to display asymmetrical risk characteristics, the Sortino ratio is often preferred over the Sharpe ratio.

FTSE/JSE ALSI AHAI HFI

0.5 12.1

Both Sharpe and Sortino ratios are most usefully used to compare different hedge funds over similar investment periods, rather than as meaningful numbers on their own. Over the review period investors in hedge funds were considerably better rewarded for the downside risk that they experienced than were investors in equities. 5.5 Rolling Periodic Returns

Most risk and return measures are calculated over specific periods defined by a particular start date and a particular end date, and they can therefore hide true risk characteristics of the portfolio. In the following sections we describe techniques for reflecting consistency of returns. In order for the results to not be excessively sensitive to particular start and end dates, rolling returns should be considered. We find 12 month rolling numbers to work best, but shorter or longer periods could work equally well as long as they are not too short or too long. In Figure 5.1 we first consider only rolling 12 month returns over time.

70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% Mar-00 Mar-01

Rolling 12 month Returns

Rolling 12M AHAI HFI Rolling 12M ALSI Mar-02 Mar-03 Mar-04 Jun-00 Jun-01 Jun-02 Jun-03 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Sep-00 Sep-01 Sep-02 Sep-03 Jun-04

Figure 5.1: Rolling 12 month returns for equities and hedge funds (January 1999 to June 2004)

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This graph allows us to determine both the consistency of returns over time and the range of 12 month returns that were achieved over the period. 29.0% for the equity index. 5.6 Snail Trails In particular it allows us to consider the worst 12 month return experienced over the period. In the case above that was 14.8% for the hedge fund index and -

A useful tool for tracking consistency of performance and for reflecting both the short term risk characteristics and the longer term risk characteristics of a portfolio, as well as the portfolios long term returns, is the snail trail. Snail trails are pictorial representations of the consistency of the risk and return characteristics of a portfolio.

AHAI HFI & ALSI Snail Trails

70% 60% 50% 40% 12 Month Return 30% 20% 10% 0% -10% -20% -30% -40% 0% 5% 10% 15% 20% 12 Month Risk 25% 30%
JSE A ll Share Index A HA I HFI

Figure 5.2: 12 month risk and return snail trails for equities and hedge funds (January 1999 to June 2004)

The ideal is for the funds snail trail to remain within the top left area of the diagram, and for the trail to remain tightly bunched around a particular area. 5.7 Proportion of Negative Return Months, and Average Return in Such Months

Effective downside risk management should reflect in a low proportion of months which result in negative returns and in a low average negative return in those months.

Percentage Months Negative FTSE/JSE ALSI AHAI HFI 48.5% 9.1%

Average Negative Month -3.6% -0.3%

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5.8

Drawdown from Peak Analysis The

A drawdown from peak analysis considers any losses incurred subsequent to a previous higher value. The analysis tracks the subsequent loss until recovery back to the previous highest value is achieved. analysis begins once again when a further drawdown is experienced from a subsequent peak value. The analysis highlights the frequency of drawdowns, the depth of these drawdowns and the time until recovery back to the value prior to the commencement of the drawdown. Effective risk management should result in fewer drawdowns and when drawdowns do occur, they should be less severe and recovery should also be achieved more rapidly.

Draw dow n From Peak Analysis, AHAI HFI and ALSI -5.0 -10.0 -15.0 -20.0 -25.0 -30.0 -35.0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Aug-99 Aug-00 Aug-01 Aug-02 Dec-03 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Aug-03 Apr-04 Draw dow n ALSI Draw dow n AHAI HFI

Figure 5.3: Drawdown from peak analysis for equities and hedge funds (January 1999 to June 2004)

Given the few negative months experienced by the hedge fund index and the low level of these negative returns, the drawdowns experienced by the hedge fund index are difficult to identify in the figure where the scale is set to accommodate the drawdowns experienced by the equity market. Drawdown analysis can also be used to investigate the benefits of combining particular hedge funds together in a portfolio. Combining hedge funds that experience drawdowns at the same time as each other will have less diversification benefit than combining hedge funds together that experience drawdowns which do not coincide with each other.

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6.

IDIOSYNCRATIC VERSUS SYSTEMIC RISK IN HEDGE FUND INVESTING

The risks associated with any particular asset are either idiosyncratic (unique to that particular asset) or systemic (common with other similar assets) in nature. Idiosyncratic risks can be diversified away by building a portfolio of risky assets, if the returns of these assets have low covariances with those of the other assets in the portfolio. What remains when the idiosyncratic risks have been diversified away are the systemic risks, which can not be diversified away because they are common to all the assets in that class. That hedge funds have high levels of idiosyncratic risks and low levels of systemic risk should be reasonably obvious from the description of how hedge fund managers construct their portfolios, set out in Chapter 1. A hedge fund manager starts with a portfolio of cash that can be deployed towards trading ideas that are expected to add value to the portfolio in absolute return terms. The hedge fund manager builds a portfolio of trading ideas that he has generated. While there may be some ideas that are common to a number of hedge fund portfolios at the same time, for example when a large merger or unbundling is expected, there is generally little reason for two hedge fund managers to include the same trades in their portfolios at the same times. Even where common trading ideas appear in different hedge fund portfolios, the money management aspects of the trade (entry and exit levels, stop losses and amount of capital employed) will tend to dominate the trade itself in the effect of the trade on the funds returns. Hedge funds are therefore at any time a unique reflection of the ideas and skills of the manager running that fund. One would therefore expect considerably lower levels of commonality between two hedge funds managed by different hedge fund managers, than one would expect from two equity funds managed by different equity fund managers, as the latter will both be dominated by what happens in the equity market as a whole a systemic risk. If hedge funds have high levels of idiosyncratic risk and low levels of systemic risk, diversifying between a number of hedge funds should result in significantly lower levels of portfolio risk. Figure 6.1 compares the rolling 12 month volatility of individual hedge funds with the 12 month rolling volatility of a portfolio of hedge funds. We use the average 12 month rolling volatility of the individual hedge funds that comprise the AHAI Hedge Fund Index and the 12 month rolling volatility of the AHAI Hedge Fund Index itself. The comparison shows the lower volatility of the portfolio of hedge funds relative to the individual hedge funds. The volatility of the portfolio of hedge funds reduces over time as the number of hedge funds included in the portfolio increases and as the average volatility of the funds that are included in the index decreases.

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Rolling 12 Month Risk


12.00%

Average Hedge Fund AHAI HFI


10.00%

8.00% T o tal R isk

6.00%

4.00%

2.00%

0.00% 36525 36585 36646 36707 36769 36830 36891 36950 37011 37072 37134 37195 37256 37315 37376 37437 37499 37560 37621 37680 37741 37802 37864 37925 37986 38046 38107 38168

Figure 6.1: Rolling 12 month volatilities for average hedge fund and for hedge fund index (December 1999 to June 2004)

Figure 6.2 shows the reduction in volatility that can be achieved by adding additional hedge funds to a portfolio of hedge funds. The initial portfolio comprised the hedge fund with the highest volatility. The second portfolio comprised that hedge fund together with the hedge fund that exhibited the second highest level of volatility, and so on. The analysis therefore reflects the boundary of the problem rather than the mid-point of the problem.

Risk Reduction over Number of Funds

18.0% 16.0% 14.0% 12.0%


Total Risk

10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20


Num ber of Funds

Figure 6.2: Reduction in portfolio volatility as number of hedge funds in the portfolio is increased

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This analysis has a number of limitations as ideally one requires more hedge funds each with a longer history to conduct the analysis more scientifically. The analysis does however reflect the same characteristics as found in analyses carried out in the global hedge fund industry.

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7.

FUNDS OF HEDGE FUNDS

Hedge funds were initially the preserve of high net worth individuals and were largely ignored by institutional investors. However, as hedge funds have been subjected to greater study by academics and investment industry practitioners, and as hedge funds have become better understood by institutional investors, institutional investors have come to represent a greater proportion of the total assets invested in hedge funds. Investors wishing to allocate a portion of their assets to hedge funds can either construct their own portfolios of hedge funds, or they can invest in a Fund of Hedge Funds (FoHF) where the portfolio of hedge funds is managed by a professional FoHF manager. The decision whether to invest directly into hedge funds or to invest via a FoHF portfolio will depend largely on the resources that the investor has available, both in terms of time and in terms of skill, to manage their hedge fund investments, as well as the perceived benefits relative to the costs of each approach. FoHFs greatly simplify the ability of an investor to allocate a portion of their portfolio to hedge funds. There are both advantages and disadvantages to accessing hedge funds through a FoHF. Some of these are: 7.1 Advantages

Hedge fund strategies are complex and specialist skills are required to understand the strategies followed and the risks associated with these strategies. Furthermore the investor can not take for granted that the operational infrastructure backing the fund is sound and the investor should therefore investigate the back and middle office infrastructures before making an investment into the fund. This analysis is time consuming for any one hedge fund being analysed and more so when multiplied by the number of hedge funds that need to be analysed in order to build a properly diversified portfolio of hedge fund investments. FoHF managers will usually employ a range of investment professionals to analyse hedge funds on a full time basis, where these professionals have experience in managing or administering assets themselves. Some investors will employ a FoHF manager on a consulting basis to advise on the construction and ongoing management of a portfolio of hedge fund investments on a bespoke basis in order to access these skills. FoHFs will typically provide their investors with a widely diversified portfolio of hedge funds. Diversification will usually be between different hedge funds, between different hedge fund strategies and between different hedge fund management companies. FoHF companies usually require considerably lower minimum investments from their investors than individual hedge funds may require. They are thus able to provide hedge fund exposure to smaller investors, as well as provide larger investors with exposure to a wide spread of hedge funds without the investor having to satisfy the minimum investment requirements of each hedge fund. FoHFs seek to provide their investors with intelligent diversification between the hedge funds that they invest in rather than simple diversification. The FoHF manager seeks to identify the better hedge funds for use in their FoHF portfolios. The FoHF manager seeks to identify hedge fund strategies best suited to

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the actual risk and return objectives of the investor. They seek to blend hedge funds together so as to produce a portfolio of hedge funds that has specific risk levels and asset class correlations appropriate for the intended use of the FoHF product. FoHFs are usually able to provide their investors with better liquidity than provided by the underlying hedge funds. FoHFs usually transact monthly, with one month notice for redemptions, while the underlying hedge funds will have a range of redemption terms. Hedge funds typically seek to limit the amount of assets that they manage to the right size for their strategy. The right size will differ from fund to fund based largely on the strategy followed by the fund, but the right sized portfolio is one which is large enough to generate attractive fees for the manager, but is not so large that the size impacts the managers ability to generate investment performance. investors, but will continue to accept monies from its current investors. As a hedge fund grows and approaches the desired asset size, the manager will typically close the fund to new Soon thereafter the fund may close to all additional monies. Often the only way for investors to gain access to many of the best, well established hedge funds is to invest in a FoHF that already has access to that hedge fund. 7.2 Disadvantages

FoHFs introduce another layer of costs into the structure. Most FoHFs charge a layer fee for their fund. The FoHF fee is paid on top of the fees charged by the underlying hedge funds themselves. When selecting individual hedge funds to invest in, the fund of hedge fund manager is interested in the expected returns from the underlying hedge funds, and the risks associated with those returns, on an after fees basis. Some FoHFs negotiate fee rebates from some of the hedge funds that they employ and these are usually rebated to the investors in the FoHF product. Fee structures vary in the FoHF industry, but are typically in the order of a basic fee of 1% per annum plus a performance fee of 10% of performance. As with hedge fund fees there may also be hurdle rates and high-watermarks that apply before performance fees are due. These fee levels are high when compared with those charged by long-only portfolio managers. are as high and therefore the fee levels are warranted. FoHF

managers would argue that the asset base in the industry is much smaller and the resource requirements Ultimately it is up to the investor to decide whether the fees are acceptable relative to the value added and the costs and risks associated with constructing their own portfolio of hedge fund investments, and whether on a net of fees basis the expected returns are attractive. Some FoHF managers are not independent of the hedge funds used in their portfolios impacting the objectivity of their selection process. The FoHF manager may manage direct hedge funds within their firm and use these in its FoHF products. Alternatively, the FoHF manager may have a shareholding in some of the hedge fund management companies whose funds are included in their products. The FoHF manager may enter into a fee sharing arrangement with particular hedge funds that they employ. In some cases, where a company offers both FoHF and direct hedge funds they may get past the conflict of interest issue by undertaking to exclude hedge funds in which they have an interest from the FoHF product. This is also less than ideal.

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Given that hedge funds have not been operating in South Africa for very long, not surprisingly the local FoHFs industry has an even shorter history. However, over the past few years a number of FoHF As with the managers focusing on managing portfolios of local hedge funds have opened their doors.

global industry these businesses range widely in terms of the resources that they apply to managing their FoHF products. Some FoHF managers form part of larger asset management organisations and focus on managing in-house monies, i.e. monies allocated by clients to the house to invest in a fully discretionary manner. Other FoHF management companies focus exclusively on attracting external assets. The majority of assets currently invested in South African hedge funds relate to high net worth individuals where the assets are invested in a FoHF managed by the wealth manager advising the investor on their total investment strategy. At this stage institutional investors represent a smaller portion of the total domestic FoHF investor base. This split is consistent with the global experience where the initial investors into both hedge funds directly and then into FoHFs were high net worth individuals, with institutional investors following once they were more familiar with the asset class. South African institutional investors are already significant investors in FoHFs in terms of the offshore portion of their investment portfolios.

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8.

ABSOLUTE RETURN FUNDS

In recent years a number of South African asset management companies have launched absolute return investment products. These are multi-asset class regulatory compliant investment products that seek to deliver positive returns to their investors under all market conditions. As such their objectives are very similar to those of hedge funds. In many parts of the world the terms hedge fund and absolute return fund are interchangeable. In South Africa, many of these absolute return funds might have some exposure to hedge funds, but by and large most of these funds do not employ hedging techniques to protect their investors capital and ensure the delivery of positive returns. Instead, they employ a widely heterogeneous variety of techniques to reduce their exposure to market risk. This broad category of investment products has attracted considerable flows from both retirement funds and retail investors. The promise of absolute returns was very attractive to investors who previously had simply relied on rising equity markets to deliver returns and who were feeling the pain of negative returns once the bull market had ended. Many boards of retirement fund trustees were going back to basics and re-examining their investment strategies, setting their return objectives in absolute return terms. To be offered investment products that expressed their return targets in the same terms as the trustees return objectives made the sale a relatively easy one. In this section we consider whether the techniques identified for investigating the risk characteristics of particular hedge funds can be usefully applied to gaining a better understanding of the absolute return funds. By labelling a fund as an absolute return fund, the success of the fund must be measured in absolute return space, either in true absolute return terms or in terms relative to inflation. of setting benchmarks in these terms could be one or more of the following: setting performance expectations for investors, a marketing ploy designed to appeal to investors own objectives, or a basis for determining performance related fees. Almost all absolute return funds use real return benchmarks. As these benchmarks are not passively investable, the purpose

The range of absolute return products includes funds with a wide variety of return objectives as reflected by the benchmarks used by the asset managers to set expectations for their product. Return objectives are typically set in real returns terms and the majority of products have objectives in the range from inflation plus 3% per annum to inflation plus 8% per annum. The considerations that an investor contemplating investment in an absolute return fund must apply are similar to those applicable prior to investing in a hedge fund. The analysis should be broken down into (a) a qualitative analysis of the strategies followed by the fund manager to determine whether these are likely to deliver the levels of return sought over the medium to long term, whether they are likely to deliver these returns irrespective of market direction and whether the returns are likely to be sufficiently absolute in nature, and (b) a quantitative analysis the funds track record to investigate whether the fund has historically delivered according to its absolute return objective.

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No simple criteria exist for determining the success of absolute return funds. Any investor investing in a fund that markets itself as an absolute return fund will certainly expect the fund to deliver positive returns over almost all time periods, but at levels in excess of the returns available on risk-free assets over longer periods. It is likely that those funds that strive for greater returns also end up delivering more volatile returns. Given that downside risk management will be important to any investor that wishes to invest in an absolute return fund, the same quantitative measures of downside risk management used to assess hedge funds and described in Section 5 should also be useful in measuring the absolute return effectiveness of these funds. Absolute return funds, like hedge funds, are a heterogeneous group of funds, with funds following a variety of strategies to limit risk in their portfolios. For the purposes of illustrating the analyses we have used the return series of two absolute return funds available to South African retirement funds. The particular funds were chosen for three reasons (a) they have reasonable track records to work with, (b) they are amongst the larger absolute return funds in the market, and (c) they reflect the characteristics that we are keen to demonstrate. Strategy Analysis: Absolute return funds that do not hedge out market risk are likely to have high levels of sensitivity to the overall market direction. Figures 8.1 and 8.2 show the sensitivity of the monthly returns of two absolute return funds to equity market returns. Fund A employs no explicit hedging strategy, while Fund B employs a dynamic hedging strategy to reduce equity market risk.

15.0%

10.0%

5.0%

0.0%

-5.0%

y = 0.40 x + 0.01 R = 0.70


2

-10.0%

-15.0% -15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

Figure 8.1: Sensitivity of monthly returns of Absolute Return Fund A with returns of equity market

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15.0%

10.0%

5.0%

0.0%

-5.0%

-10.0%

y = - 0.01 x + 0.01 R 2 = 0.00

-15.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0%

Figure 8.2: Sensitivity of monthly returns of Absolute Return Fund B with returns of equity market

By investigating the relationship between the returns generated by an asset managers absolute return fund and the balanced fund managed by the same asset management house, the prospective investor can gain an insight as to whether the absolute return fund is managed independently of the balanced fund or whether the absolute return fund is merely a variant of the managers balanced product with a lower risk profile. Figures 8.3 and 8.4 show the monthly return series of Fund A and Fund B plotted against the monthly return series of the balanced portfolios managed by the same asset management houses.

12% Manager A - Absolute 10% 8% 6% 4% 2% 0% -2% -4% -6% Mar-02 Mar-03 Dec-99 Mar 2001 Dec-01 Dec-02 Dec-03 Mar-04 Jun-01 Jun-02 Jun-03 Mar-2000 Sept 2000 Dec 2000 Sep-99 Sep-01 Sep-02 Sep-03 Jun-04 JuneManager A - Global Balanced

Figure 8.3: Monthly returns for Absolute Return Fund A and for global balanced portfolio managed by same house

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12% Manager B - Absolute 10% 8% 6% 4% 2% 0% -2% -4% -6% Oct-02 Feb-03 Oct-03 Feb-04 Jun-02 Jun-03 Dec-02 Dec-03 Apr-02 Apr-03 Aug-02 Aug-03 Apr-04 Jun-04 Manager B - Domestic Balanced

Figure 8.4: Monthly returns for Absolute Return Fund B and for domestic balanced portfolio managed by same house

As Fund A is a portfolio with an offshore component, it has been compared with the global balanced portfolio managed by the same house, while Fund B has been compared with the domestic balanced portfolio managed by Manager B as the portfolio does not have any offshore exposure. It should be clear from these two analyses that Fund A, which employs no explicit hedging strategies, is managed in a manner very similar to the manner in which the asset management houses balanced product is managed, and that Fund A has a high level of sensitivity to equity market direction. This fund will therefore depend to a large extent on equity market returns in order to achieve its return objectives. It should also be clear that Fund B demonstrates a return pattern which, while clearly subject to similar forces as the balanced product, demonstrates significantly greater capital protection qualities and no sensitivity to equity market direction. Quantitative Analysis: In the paragraphs below we apply the techniques described in Section 5.2 to investigate the absolute return characteristics of these two absolute return funds. In order to demonstrate the analysis over the as long a period as possible we first show the analysis using only Fund A which has a longer track record, and then using both funds for the duration of the track record of Fund B. The AHAI Hedge Fund Index and the average return of the global balanced funds reported in the Alexander Forbes Large Manager Watch Survey (LMA) are used for comparative purposes. This average was calculated and rebalanced monthly.

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Tables 8.1 and 8.2 set out various risk measures for the absolute return funds and for the two comparative measures over the two different time periods.

Risk Statistic Total Risk Downside Risk % Months Down Average Negative Monthly Return Sharpe Ratio Sortino Ratio Maximum Drawdown

ABS FUND A 9.7 3.9 37.9 -1.5 0.6 1.6 -7.6

AHAI HFI 5.0 1.1 10.3 -0.3 2.02 8.9 -0.9

LMA 12.8 6.0 41.4 -2.3 0.2 0.5 -15.5

Table 8.1: Comparative risk measures for Absolute Return Fund A, hedge funds and the average global balanced retirement fund portfolio (since inception of Fund A)

Risk Statistic Total Risk Downside Risk % Months Down Average Negative Monthly Return Sharpe Ratio Sortino Ratio Maximum Drawdown

ABS FUND A 11.2 6.0 51.9 -1.6 -0.2 -0.4 -7.6

ABS FUND B 5.4 0.6 22.2 -0.4 0.64 7.14 -0.8

AHAI HFI 3.7 0.2 7.4 -0.1 2.4 37.3 -0.2

LMA 11.8 6.4 44.4 -2.1 -0.3 -0.6 -15.5

Table 8.2: Comparative risk measures for Absolute Return Fund A, Absolute Fund B, hedge funds and the average global balanced retirement fund portfolio (since inception of Fund B)

The risk statistics show that Fund A experienced lower risk levels than the average global balanced fund as reflected by almost all the risk measures over both time periods. average global balanced fund over the period. A purely subjective assessment would suggest that this fund experienced risk levels approximately 75% of those experienced by the Fund A does not employ explicit hedging techniques to protect capital and the approximately 25% reduction of risk levels in the portfolio can thus be ascribed to the risk reduction techniques employed by the portfolio manager. Fund B clearly experienced lower risk levels than Fund A using each of the measures. The downside risk measures in particular demonstrate the greater extent to which the fund succeeded in protecting investors capital over the period. The risk levels appear to be closer to those experienced by hedge funds than those experienced by the average retirement fund portfolio. The improved downside risk

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management can largely be attributed to the explicit hedging techniques employed by the asset manager, who uses a dynamic hedging technique applied to an actively managed portfolio. One other significant difference between the two portfolios is that Fund B is limited to domestic assets, whilst Fund A includes an offshore component where the currency effects are not hedged. Figure 8.5 shows the risk and return snail trail for Fund A shown against those of the two comparative measures. Figure 8.6 shows these trails for Fund B over the history of the fund. These analyses confirm the findings of the total period risk analysis. Fund A has a risk and return profile closer to the average balanced global retirement fund portfolio than to that of hedge funds, whilst Fund B has a risk and return profile closer to hedge funds than to the average balanced global retirement fund portfolio.

40.0%

30.0%

20.0%

10.0%

0.0%

-10.0%

Absolute Fund A Balanced Manager Average Hedge Funds

-20.0% 0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

Figure 8.5: 12 month risk and return snail trails for Absolute Return Fund A, hedge funds and the average global balanced retirement fund portfolio (since inception of Fund A)

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40.0%

30.0%

20.0%

10.0%

0.0%

Absolute Fund B -10.0% Balanced Manager Average Hedge Funds

-20.0% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%

Figure 8.6: 12 month risk and return snail trails for Absolute Return Fund B, hedge funds and the average global balanced retirement fund portfolio (since inception of Fund B)

The analysis is skewed by the fact that both Fund A and the balanced global retirement fund portfolios each included exposure to offshore assets, whilst Fund B and the hedge funds did not. Retirement funds concerned with downside risk should consider the merits of including unhedged offshore exposure in a portfolio that focuses on delivering absolute returns. Given the current regulatory environment in South Africa, currency risk can not be hedged and hence the portfolios with offshore exposure are fully exposed to the vagaries of the Rand. Figures 8.7 and 8.8 examine the drawdown from peak experience of the two absolute return funds, compared with that of the average balanced retirement fund portfolio. The analysis once again shows that Fund A has managed downside risk better than the average balanced global retirement fund portfolio. It does however also confirm the high level of correlation between the drawdowns experienced by the portfolio and those experienced by relative return focused portfolios, a feature identified in Figure 8.3, where the returns earned by Fund A were compared with those earned by the same asset management houses relative return focused portfolio. The effectiveness of the downside risk management techniques applied by Fund B is clearly demonstrated in Figure 8.8. The maximum drawdown experienced by Fund B over the period was a very reasonable 0.8%, as set out in Table 8.2.

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-2.0 -4.0 -6.0 -8.0 -10.0 -12.0 -14.0 -16.0 -18.0 Dec-99 Dec-00 Dec-01 Dec-02 Aug-99 Aug-00 Aug-01 Aug-02 Aug-03 Dec-03 Mar-04 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 May-04
The investor should

Draw dow n Large Manager Average Draw dow n Absolute Fund A

Figure 8.7: Drawdown from peak analysis for Absolute Return Fund A and average global balanced retirement fund portfolio (since inception of Fund A)

-2.0 -4.0 -6.0 -8.0 -10.0 -12.0 -14.0 -16.0 -18.0 Mar-02 Mar-03 May-03 Jan-03 May-02 Nov-02 Sep-02 Nov-03 Sep-03 Jan-04 Jul-02 Jul-03 Draw dow n Large Manager Average Draw dow n Absolute Fund B

Figure 8.8: Drawdown from peak analysis for Absolute Return Fund B and average global balanced retirement fund portfolio (since inception of Fund B)

A retirement fund which adopts an investment strategy which limits the downside risk and hence chooses to invest its assets in investment products that claim to be absolute return focused should avoid simply accepting a products validity on the basis of the asset manager labeling the portfolio as an absolute return fund or an inflation beating fund. Like hedge funds, absolute return funds launched in South Africa are complex and the strategies that they follow are varied. Before investing in an absolute return fund, the investor would benefit greatly from Where the portfolio has a track record there are a number of quantitative examining the strategies adopted by the asset manager in order to assess the likelihood of the portfolio achieving its objectives. analyses that the investor can conduct to explore the nature of the fund further.

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satisfy himself that the asset manager follows strategies that can be expected to deliver the level of returns required by the fund whilst still providing acceptable levels of downside risk management.

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9.

CONCLUSION

The track record of the domestic hedge fund industry is still very short and the veracity of the returns earned by these funds is subject to further scrutiny. However, even if one penalises the past return series both by lowering the return levels and by increasing the volatility levels, a strong case can still be made for the improvement of total portfolio efficiency through the inclusion of an exposure to hedge funds in the portfolio. Hedge funds will never replace conventional long only funds. Hedge funds depend in part on the

behaviour of long-only asset managers to create exploitable inefficiencies. The capacity for hedge fund strategies is limited and hedge funds will thus always be limited to a small portion of the overall investment market. Larger local investors may find the capacity restrictions off-putting, but smaller investors should not find overall capacity restrictions limiting. It is a simple truism that if investors wish to achieve investment returns in excess of the risk-free rate of return they must be willing to accept investment risk. The challenge for the investor is to understand the characteristics of the investment class and of the particular investment product that is being considered. The investor needs to understand the risks to which he is exposed and how these risks are being managed. Return numbers alone are not sufficient for the investor to gain this understanding. A return series for a portfolio only represent one of the multitude of alternative histories that the portfolio could have experienced. By carefully analysing the strategies and processes followed by the fund manager an investor should be able to better understand the true risks associated with investment in that fund. Hedge funds are a highly heterogeneous group of investment vehicles. The characteristics of any one

fund that labels itself as a hedge fund may be quite different from those common to most other hedge funds. There will be good hedge fund managers and less skilful hedge fund managers. This is particularly true of an emerging hedge fund industry such as the South African market. Careful analysis is therefore essential before investing in any particular hedge fund. Considerable benefits can be gained by diversifying ones hedge fund exposure over a number of hedge funds. Greater benefits can be gained by using hedge funds that follow strategies that are appropriate for the investors overall investment objectives and by blending hedge funds with complementary risk characteristics together in a portfolio of hedge funds. Investors can achieve this by constructing their own portfolio of hedge funds or by employing the services of a fund of hedge funds manager.

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APPENDIX 1 THE AHAI HEDGE FUND INDICES African Harvest Alternative Investments (AHAI) maintains a series of South African hedge fund return indices for research purposes. Six indices are maintained. Four of these are strategy specific indices and represent the four strategy

categories described in Section 1.6, namely: Relative Value Market Neutral Equity Long/Short Variable Bias Equity Long/Short Trading The fifth index combines the two equity long/short hedge fund strategies into a single index. The sixth is an overall index covering all four strategies. In the construction of these indices, these following rules are applied: The hedge fund must not be limited to proprietary capital. It must be a fund open to external investors. Incubator funds will only be included in the indices once they complete the incubation process and are opened to external investors. The funds need not still be open to new investors, but must still manage assets of external investors. The fund must exceed R 10 million in size. included for funds that satisfy the size criterion. The indices are based on monthly returns, net of the hedge fund managers total fees, but gross of tax. AHAI reserves the right to exclude funds that AHAI considers not to be true hedge funds. For example, hedged equity funds and absolute return funds that do not employ hedging techniques are excluded. To avoid survivorship bias, funds that cease operating will be included in the index for the period that they were in operation. Each hedge fund in operation at a particular time is equally weighted in the indices. Where a hedge fund manager manages multiple pools on a similar basis, either a composite return is used or the return of the flagship fund, being the fund open to external investors, is used. Where a hedge fund manager or team manage more than one fund, the individual fund returns are averaged to produce a single return for that manager. The funds that comprise the indices have not been frozen at this stage. If data series are obtained for additional hedge funds that satisfy the requirements of the indices, these will be included retrospectively and the past index numbers will be restated. When AHAI is satisfied that Track records based on smaller asset sizes are

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the data included in the indices is sufficiently representative of the industry, subsequent funds added to the index composition will be included on a prospective basis only. Hedge fund indices, by their nature, have a subjective element as they will be influenced by the ability of their constructors to source hedge fund return data and by the construction rules applied by their constructors. In setting the rules for the construction of the AHAI hedge fund indices, we strove to apply rules that reflect the opportunity set as we would expect institutional investors to perceive it to be. We have had to reserve the right to decide whether a fund that calls itself a hedge fund should indeed be considered a hedge fund. The barriers to entry in establishing hedge funds are low and therefore a number of very small hedge funds exist that are not likely to attract serious attention from sophisticated investors. A large number of hedge funds in our database have been excluded simply because the funds are too small. Others were excluded because the funds are not open to external investors and a large group of funds was consolidated into a single component within the index because they are managed by the same team. The African Harvest Alternative Investments South African Hedge Fund Index All Strategies (the AHAI HFI) monthly return series is provided below for the period from 1 January 1999 to 30 June 2004. The index will be updated and made publicly available every six months. represented 20 hedge fund teams. As at June 2004 the index

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The African Harvest Alternative Investments South African Hedge Fund Index (All Strategies) (Based to 100 on 1 January 1999)

MONTH Jan 1999 Feb 1999 Mar 1999 Apr 1999 May 1999 Jun 1999 Jul 1999 Aug 1999 Sep 1999 Oct 1999 Nov 1999 Dec 1999 Jan 2000 Feb 2000 Mar 2000 Apr 2000 May 2000 Jun 2000 Jul 2000 Aug 2000 Sep 2000 Oct 2000 Nov 2000 Dec 2000 Jan 2001 Feb 2001 Mar 2001 Apr 2001 May 2001 Jun 2001 Jul 2001 Aug 2001 Sep 2001

INDEX 103.9293 107.0970 116.1520 124.2105 131.7948 132.5174 135.7630 139.8571 143.9887 146.2888 152.4059 156.2542 165.1507 168.8891 167.2896 167.8746 167.8239 178.3209 179.9503 183.4279 189.3513 190.7027 195.3686 197.6318 204.3637 205.6236 210.0784 215.5124 226.9655 233.3817 234.5379 237.6262 242.5658

RETURN 3.93% 3.05% 8.45% 6.94% 6.11% 0.55% 2.45% 3.02% 2.95% 1.60% 4.18% 2.53% 5.69% 2.26% -0.95% 0.35% -0.03% 6.25% 0.91% 1.93% 3.23% 0.71% 2.45% 1.16% 3.41% 0.62% 2.17% 2.59% 5.31% 2.83% 0.50% 1.32% 2.08%

MONTH Oct 2001 Nov 2001 Dec 2001 Jan 2002 Feb 2002 Mar 2002 Apr 2002 May 2002 Jun 2002 Jul 2002 Aug 2002 Sep 2002 Oct 2002 Nov 2002 Dec 2002 Jan 2003 Feb 2003 Mar 2003 Apr 2003 May 2003 Jun 2003 Jul 2003 Aug 2003 Sep 2003 Oct 2003 Nov 2003 Dec 2003 Jan 2004 Feb 2004 Mar 2004 Apr 2004 May 2004 Jun 2004

INDEX 241.3058 242.9980 246.1866 249.5233 249.0402 251.1792 262.8748 268.2808 267.8780 268.7015 272.9480 279.3099 283.4184 289.2796 296.0790 302.3514 302.5515 305.2913 307.8288 317.7059 324.9091 333.3665 339.0504 343.2730 351.8830 360.5004 370.2259 374.3020 378.5336 384.9699 387.2603 387.2003 394.2933

RETURN -0.52% 0.70% 1.31% 1.36% -0.19% 0.86% 4.66% 2.06% -0.15% 0.31% 1.58% 2.33% 1.47% 2.07% 2.35% 2.12% 0.07% 0.91% 0.83% 3.21% 2.27% 2.60% 1.70% 1.25% 2.51% 2.45% 2.70% 1.10% 1.13% 1.70% 0.59% -0.02% 1.83%

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GLOSSARY Alpha Alpha measures the additional value added by a manager through active management independent of the return generated by the market. It measures the difference between the return on the actively managed portfolio and its passive benchmark. The term alpha is also colloquially used to refer to manager skill. Basket Trades Basket trades are more complex variations of pairs trades. The hedge fund manager builds a long/short portfolio where either one or both sides of the portfolio comprises of two or more shares, with the intention of removing his overall portfolios sensitivity to the factors common to both the long and short legs of the trade, while aiming to profit if the long side of the trade rises in price more, or falls in price less than the short side of the trade. Beta Beta measures the sensitivity of a share or portfolio to movements in the value of another asset based on past experience. Beta is most usually determined relative to the market as a whole. A portfolio with a beta of 1 is expected to move in line with the market. Low beta shares or portfolios are less sensitive to market movements than high beta shares or portfolios. Bollinger Bands Bollinger bands are a type of envelope that are plotted at standard deviation levels above and below a moving average, and are used to confirm trading signals by indicating when a price or price relationship moves out of its past trading range. Drawdown from Peak The maximum total loss in percentage terms measured relative to the previous highest value that the asset or portfolio attained. Fundamental Analysis The quest to determine a shares true value based on forecasts of future earnings. Hedging Removing specific risk, often overall market risk, by entering into a transaction of the opposite direction in securities which have common characteristics with those already held in the portfolio, in order to neutralise the overall portfolios sensitivity to adverse price movements arising from factors that affect securities sharing these common characteristics. High-watermark A Process that ensures that performance fees are not paid twice on the same performance as the manager must first recoup any losses incurred subsequent to any previous positive performance before he becomes eligible for performance fees once again.

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Hurdle Rate The minimum return that a manager must achieve before he qualifies for performance fees. Independent Long Position A security bought in the expectation that the price will rise. The security in not directly hedged as it would usually be expected to have a high probability of rising in value irrespective of what happens in the rest of the market as the security trades considerably below its fair value. Independent Short Position A security sold short in the expectation that the price will decrease. The trade is executed simply on the basis that the particular security is overpriced and the short seller is confident that the price will decrease. Long Position Owning a positive amount of a security. Mean Reversion Arbitrage Trades Long/short trades based on a historical price relationship that has broken out of its usual range. The breakdown in price relationship is expected to be temporary and the hedge fund manager expects to profit when the relationship re-establishes itself and reverts to normal, by taking a long position in the relatively underpriced security and a short position in the relatively overpriced security. Merger Arbitrage Trades A merger arbitrage trade involves the hedge fund manager taking a long position in the shares of a company that is being taken over via an exchange of shares, and a short position in the shares of the company that is doing the taking over. When an intended merger is announced where shareholders in Company A will receive a fixed number of Shares in Company B once the merger is effected, the shares of Company A usually trade at a discount to the exchange ratio times the price of Company Bs shares. The discount reflects the level of uncertainty as to whether the merger will proceed or not. If the hedge fund manager is more confident than the rest of the market that the merger will proceed, he can profit from the discount if he is proven correct. Pair Trades A pair trade involves taking a long and a short position in two related shares with the objective of hedging out risks arising from factors common to the two shares, while profiting from correctly identifying the relatively overpriced share and the relatively underpriced share. Quantitative Model A model built by a quantitatively inclined investment analyst based on some favoured financial theories which use historical data to set parameters designed to generate mostly medium term trading ideas. Short Term Directional Trade This an unhedged long or short position taken in order to profit from expected short term price changes in the underlying security. These trades are typically selected on the basis of technical trading models rather than any fundamental view as to the correct price of the security.

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Shorting Holding a negative exposure to an asset. The security is borrowed from its owner and sold in the market. The short seller is obliged to buy the security back at a later date to return it to its original owner. Technical Analysis The study of share price movements and trading volumes with the objective of anticipating the future direction of prices. Trading Model A model built by an investment analyst to generate mostly short term trading ideas based on short term price momentum.

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REFERENCES AND SUGGESTED FURTHER READING AIMA South Africa: Hedge Fund Booklet; 2004 Applications of Institutional Investments Working Party: Hedge Funds for Pension Funds; [Presented to the Faculty and Institute of Actuaries 2001 Investment Conference] Caslin JJ: Hedge Funds; [Presented to the Faculty of Actuaries, 16 February 2004] FSB, ACI and AIMA: The Regulatory Position of Hedge Funds in South Africa, A Joint Discussion Paper; March 2004 Jaeger RA: All About Hedge Funds; McGraw Hill 2003 Nailana R: Hedge Funds versus Long-only Funds: The South African context; [Research report published by Cadiz Financial Strategists, Feb 2004] Nailana R: Hedge Fund Benchmarking in South Africa; [Research report published by Cadiz Financial Strategists, June 2004] Nailana R: Hedge Fund Diversification and Style Allocation in South Africa; [Research report published by Cadiz Financial Strategists, June 2004] Nicholas GN: Investing in Hedge Funds; Bloomberg Press 1999

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About the authors: Simon Peile BBusSc, AIAA, CFP, FASSA, FFA Simon qualified as an actuary in 1987 and has worked as an actuary and strategic consultant to retirement funds in the U.K., Australia and South Africa. drawn to resolving investment problems. company. Willem van der Merwe BSc (Actuarial), BCom (Hons in Financial Analysis), CFA Willem headed up the Quantitative Research division of a major South African asset management house for six years. In this role he was exposed to a wide range of quantitative finance problems, and in 2002 he was instrumental in the developed of the investment research and portfolio construction methodologies for the companys London-based fund of hedge funds operation. In 2003 he joined African Harvest Alternative Investments as a founding member. As a consultant his interest was increasingly In 2003 he left the consulting industry and was a founding

member of African Harvest Alternative Investments, a specialised fund of hedge funds management

Acknowledgements: The authors would like to thank the following for reviewing and commenting on this paper: Cathy Fivaz of Quantscape, Lars Piepke and Graeme Rate of Decillion Fund Managers, Kevin Shames of AIMA South Africa and Magda Wierzycka of African Harvest Fund Managers, as well as Mayur Lodhia of African Harvest Alternative Investments for his help in working the numbers. The authors would also like to thank the many hedge fund managers with whom they have spent innumerable hours discussing hedge fund strategies, and those who submitted their data for inclusion in the AHAI Hedge Fund Indices.

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