Should hedge funds form part of a well-diversified portfolio?

CIARAN RYAN: Hedge funds have become a critical part of the investment landscape, but what’s most impressive is the range of hedge funds that have sprung up in the last 10 years, focusing on different investment styles but all pretty much with the same objective in mind – to reduce risk and achieve a target outcome with the ability to be both long and short the market, often using derivatives and leverage to generate higher returns. That’s the promise.

Many people remain wary of hedge funds, however, for a variety of reasons – whether it’s underperformance, high fees or high risk. Should hedge funds form a part of any well diversified portfolio? Well, joining us to explore the subject is Murray Winckler, co-founder and portfolio manager with Laurium Capital.

Welcome, Murray. Let’s dive right in here. Are hedge funds a high-risk investment, what are the risks, and how do you manage those risks?

MURRAY WINCKLER: Hi, Ciaran. Firstly, to label hedge funds all as high risk is quite misleading. The risk profile of hedge funds varies, depending on the mandate of the fund. That is the key. There are definitely some very aggressive hedge funds that use a lot of leverage, particularly globally. Globally the industry is [worth] $4 trillion [more than R67 trillion], and there are 9 000 different funds, some of them very aggressive, some of them more conservative.

South Africa has [fewer] funds, [the industry is] a lot smaller, worth only R70 billion. It’s very small, and the managers in South Africa are pretty conservative by global standards, and from a risk point of view I think the large managers are fairly risk-averse in the way they run their funds.

So what are the risks, really? I guess, compared to a long-only fund, [in] a long-only fund you buy your 20, 30, 40 stocks and they go either up or down.

The big thing in hedge funds is you have the ability to short.

You sell the share and you assume it’s going to go down, and then you try and buy it back at a lower price and you make money. Now, if you have a long-only share, if you put R100 in, you can lose only R100. If you go short a share, you are betting it goes down, so if you have R100 in, it can go up 100%, [or] it can go up 200% if you get it wrong.

So one of the big risks in a hedge fund is your shorts; and the other risk is that people are able to use leverage, as you mentioned.

It depends how much leverage you are you gearing up the fund [with]. So, if you gear up too much, your risks can go up a lot. But the gearing levels are pretty low in South Africa – maybe up to, on average, 40%, [with] a gross gearing ratio of 1.4, maybe 1.5. So fairly conservative.

CIARAN RYAN: Okay. Hedge funds can be structured to benefit from virtually any market environment. I mentioned in the beginning the ability to go either long or short. Is there a particular market environment that’s best for hedge funds?

MURRAY WINCKLER: I’m going to try to sort of narrow it down because, as you say, it can vary [in line with] what the mandate of the fund is and how they operate. So they can make money when markets are falling. If they take a view that they’re going short, they’re worried about markets, so they can position that. I mean, you can have a market-neutral fund.

We run a market-neutral fund, so it really doesn’t take a directional view. We run a medium-risk fund, which is sort of 50% net exposure to the market, and then a more aggressive one that probably runs at about a 75% net exposure. It all depends on the mandate, again.

But if we look at the markets – and I speak just for the South African hedge fund industry, [the] main of which, in the bulk is, I guess, long-short equity – a strong bull market, probably like the States, that you had for 10, 12 years, the last 12 years or so.

That’s not a great environment because of very strong returns from the market, and beta is very high, so long-only funds can do pretty well. I would see a sort of market that is probably rising, albeit modest, and with a bit of volatility. That, for us, would probably be the best market to be in.

But if we look [at] this year, a lot of the hedge funds in South Africa have done pretty well. So our market was small, down by the end of last month; that’s probably flat year-to-date now [in] total return. [For] hedge funds when the market was down last year, the average for the index long-short was probably about 5%, 6% up for the year, which was fairly decent against a market that was a bit down. So in this type of environment, when there’s a lot of uncertainty, hedge funds tend to do fairly well.

CIARAN RYAN: Okay. What about the opportunities that you are seeing in the market at the moment, and what are the factors keeping you awake at night?

MURRAY WINCKLER: At the moment one of the things [is] South Africa’s doing quite well, I guess, because [of] our resource exposure. So we’ve done better than the US, better than the global industries year to date. Our market’s flat in dollars; we are probably 5% down year to date, whereas the US is probably about 8% down. If you look at the global indices, [they are] 15% to 18% down year to date. So we are doing fairly well because of resources. On the ‘long’ stocks we liked the diversified resources and our banks.

The South African banks are doing extremely well, the index is probably up 20%-plus year to date. That’s really driven by a strong rebound, [with] provisions, credit losses a lot lower than expected, and reasonable demand out there. So the banks’ earnings are going up this year sort of 20%, 25%, and dividend yields are 7% or so. It looks quite good.

Diversified resources, [if] we look at Glencore and Billiton, have been doing very well. So we still think in an inflation environment resources do quite well. And then also on the small-cap side there’s been a lot of corporate action which plays into hedge funds.

So [with the] RMI [Rand Merchant Investment Holdings] unbundling you’re able to go long of the RMI. There’s a big discount, a 25% discount in there, and you can short the underlyings – Momentum and Discovery. By doing that you just get the rump, and there’ve been some very attractive trades on that.

RMH [RMB Holdings] has been very good. They are [following] a sort of cash-realisation strategy at the moment, which looks pretty good.

In a lot of the mid-cap space there has been quite a bit of corporate action, so that’s where one is finding a lot of opportunities in the market. And [in] SA, relative to global as a whole, the domestic side valuations are, we think, better than the global. So that’s been working pretty well.

CIARAN RYAN: And the factors that keep you awake at night?

MURRAY WINCKLER: If we think [of] South Africa, which is the bulk of what we do, the big issue from a global perspective is commodities because, if we look at our current-account surplus last year, 3% as a percentage of GDP, this year it’s probably going to be zero or a small positive.

If you go back the last 10, 15 years, we were running at about minus 4%, your swing in GDP. With commodities doing so well in South Africa, that flows through the economy and we do quite well. So that’s the space we are in relative to a lot of other countries out there.

The big thing is global growth; what’s happening in China. We think there’s going to be very big stimulus in the next 12 months coming through, notwithstanding all the lockdowns. That’s one of the concerns around global growth, and particularly [in] China. What China does is extremely important for South Africa, so that flows through on that side.

I guess everyone talks about the inflation rates. Have we peaked in inflation? What do rates do? What we do know is we don’t know where it’s going, but obviously we think about it anyway and sort of guess [as to] that.

But I think, coming back home, the single biggest thing in the SA environment is obviously some structural reform taking place, albeit slowly. But there have been some quite positive moves on the electricity side, on the transport logistics [side], public-private sort of JVs coming into place, which is positive.

But there’s a ‘key man’ risk. The one thing that one worries about is [President] Cyril [Ramaphosa]. I think it’s very important that Cyril gets a second term. I think there is a high probability that that happens – but that would be one of the big risks out there. It’s a low risk, so you’re looking for something to come from left field that surprises you.

CIARAN RYAN: Okay. Give us a few reasons why you think hedge funds should be considered as part of an investment portfolio.

MURRAY WINCKLER: I think if we just look at the hedge fund industry in SA, which is pretty small if you go back, we’ve been in business now since we started our first hedge fund 14 years [ago]. If you look at the returns for the industry, if I just think of the top five managers that probably have [had] a decent amount of assets over that period – over the last 10, 15 years they have done extremely well. They’ve given returns above the equity market since inception, compound returns well above. The volatility of those returns probably ranges between 50% of, let’s say, the All Share market or the capped Swix, to two-thirds of the vol [Volatility Index].

And then on the downside, when you’ve had drawdowns, in the two big crises we’ve seen in the last 15 years – the financial crisis, and then the Covid crisis – probably the drawdown for the industry has been literally between one-third, so max drawdown from the highest price to the lowest price, if got out at the worst price, the drawdown for the hedge funds ranges between 30% and 50% of the market.

So they protect you on the downside. They give you equity-like returns, probably better.

Well, net-net the big guys have been well ahead of that. So we are not saying they replaced long-only funds, but we think putting [it] in part of a portfolio, a 10 to 20% allocation, makes a lot of sense. The diversification on a risk-return basis will lift up the returns and lower the units of risk that you have in the funds.

CIARAN RYAN: How much do you think should be allocated to non-traditional assets in a portfolio?

MURRAY WINCKLER: Look, you have the Regulation 28, which sort of says hedge funds can be at, say, 10% [which] is what they should be in the funds. That’s from Reg 28. So I think definitely one at least should be up at those levels. And then obviously for individual portfolios, I think you could quite easily put that figure somewhere between 10% and 20% of your portfolio.

CIARAN RYAN: Murray Winkler, co-founder and portfolio manager with Laurium Capital, thanks very much for joining us.

MURRAY WINCKLER: Thank you, Ciaran.

Brought to you by Laurium Capital.

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