Edition: October / December 2016
EXPERT OPINION

The long and the short of it

Hedge funds can add value to institutional investment strategies by reducing the dependence on traditional solutions and helping solve new challenges in an uncertain environment. So says Bruce Simpson, chief executive of Sanlam Alternatives, a division of Sanlam Investment Management.

A lot of responsibility has been placed on trustees, not only to limit losses but also to make sure that there is sufficient growth in members’ retirement fund portfolios. Particularly in this environment of lower returns, it is important to offer trustees alternative opportunities for sustainable risk-managed investment growth at lower levels of volatility. Alternative investments, such as hedge funds, do precisely this. They can offer pension funds potentially equity-like returns with less volatility.

Alternative investments use non-traditional approaches. They typically offer a distinct set of attributes not commonly found in mainstream investment products e.g. short selling, derivatives and leverage to maximise investor returns irrespective of whether the markets are going up or down.

Tools of modern finance

Alternatives offer trustees the flexibility to invest widely across different sectors and asset classes, and to respond quickly to market changes, using tools that may not be available to traditional asset managers.

Non-traditional approaches have enabled hedge fund managers to profit in both bull and bear markets, and to capitalise on mispricings between similar securities. Hedge funds are designed to reduce market volatility for investors by applying these specialist strategies. They should be considered a building block for a well-diversified investment portfolio.

Derivatives are financial products that derive their value from any underlying set of assets, including equities or debt instruments. Short-selling is selling something you don’t own (have borrowed). The thinking behind this is that by the time you need to return the asset to the lender you would have been able to buy it at a cheaper price. Leverage is using debt to benefit from market movements.

Volatile markets allow hedge fund managers to profit in both upswings and downswings by going short on the stocks they believe are overvalued, and long on the stocks they regard as undervalued. Use of shorting and leverage can introduce some risk into a fund, but if used appropriately these tools can also be used to manage risk within a portfolio and to enhance returns.

Strategies in action

A relative-value hedge fund strategy exploits differences in the price or rate of the same or similar securities. It trades on gaps rather than the price of a specific security alone. The relative-value fund may take positions if the gap between prices or rates is considered to have reached its peak and is thus expected to shrink, or may take a position in a security if similar securities are experiencing price changes.

A relative-fund manager will take long positions on securities considered undervalued, while taking short positions on securities considered overvalued. Fund managers determine what they consider normal differences in prices or rates by examining historical movements, and take positions that exploit gaps until the normal state is reached.

Interest rate instruments

With fixed-income hedge fund portfolios, specific views are taken on (i) the level of the interest rate (ii) the slope of various yield curves (the fixed-rate bond curve, interest rate swap curve, forward-rate agreements curve and inflation-linked bond curve), and (iii) the curvature i.e. whether there are dislocations along the yield curves that offer relative-value opportunities. Proprietary models then determine whether there are statistically significant relative-value opportunities.

We take specific advantage of dislocations and anomalies along the term structure of interest rates (i.e. the yield curve). Here, leverage is used to combine mostly market-neutral long and short positions between different interest rate instruments to express the relative-value view. Investors thus benefit from changes to interest rates and fixed-income exposure.


Simpson . . . appropriate for all seasons

The idea is to hedge the risk of yield fluctuations and reduce the dependence on cash returns (driven by interest rates and inflation). Most of our strategies are hedged and therefore less risky than typical long-only funds.

We aim to keep our fixed-interest hedge funds as liquid as possible and our returns are uncorrelated to other asset classes. We therefore don’t experience the same kind of drawdowns that one would experience in vanilla long-only funds during times of market turmoil.

Further, we run stop-losses on directional positions, enabling us to cut positions when the market proves a position is wrong. For example, whereas the JSE all-bond index lost nearly 7% in December as a result of ”Nenegate”, we were down only 0,8%.

 

Long-short strategies

Long/short equity is a fund management approach that involves combining both long positions (buying shares) and short positions (selling stocks borrowed) in order to make money. We all know about ”buying low and selling high”. But what if you could ”sell high and then buy low”? That is exactly what we do in hedge funds.

By using this approach it may be possible to double the number of ways to make money. By being able to sell high and buy low, we can also make money out of falling markets because we have a significantly bigger toolbox.

Our approach is thematic. We dig into the economic forces that are driving the world economy and the local factors that impact stocks. We look though our investment telescope and ask what the economy will look like 18 months from now.

What is going on with consumer confidence, thus should we be buying or selling retailers? Are populations getting older or younger, thus should we be investing into hospitals or schools? Will there be more electric cars on our roads in 10 years’ time and will we even have our hands on steering wheels, thus should we invest in companies that make automotive sensors and computer chips?

We build up a set of themes and find companies, with strong managements, that reflect our views. We also look for the weakest players, vulnerable to poor conditions, and build a portfolio of long and short stock positions. We combine this with an active trading approach that ensures we cut our losses quickly. This allows us to create a fund that gives a consistent return.

Multiple-strategy hedge funds

They work across a combination of two main asset classes i.e. fixed income and equities. The fixed-income book is made up of instruments such as bonds, interest-rate derivatives (e.g. swaps) and currencies. The equities book comprises stocks and equity derivatives. Uniquely, our two books are managed in conjunction with each other i.e. the managers aim to exploit opportunities in multiple asset classes while simultaneously targeting low correlations to the direction of these asset classes.

Within each of the two books, there are different strategies. The primary focus is diversification of exposures to manage and reduce risks, ultimately to bring smooth ‘alpha’ generation and long-term risk-adjusted returns.

In a nutshell

Alternative investments allow the creation of a retirement fund portfolio with superior risk-return characteristics. Giving pension fund trustees access to a broad set of innovative investment tools, alternatives ensure the protection and growth of fund members’ wealth regardless of market movements.

Sanlam Investment Management (Pty) Ltd (”SIM”) is an authorised Financial Services Provider. This article is intended for information purposes only and the information in it does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Independent professional financial advice should always be sought before making an investment decision.

www.sanlaminvestments.com