Blue Chip Issue 79

HEDGE FUNDS
funds can take naked derivative positions. While being more
flexible and allowing for leverage using derivatives, this also adds
to the risk level as these can backfire if not done appropriately.
These three additional sources of investment flexibility give
hedge funds the ability to deliver different patterns of returns,
but they also create a bigger opportunity set for getting them
wrong. This suggests that they are indeed in a different category
from a fund management perspective. This also means that risk
management is the foundation for any successful hedge fund
manager. The implication is that investors must be able to
assess and trust in their manager’s risk management processes.
It certainly does not, however, mean that all hedge funds will
blow up.
Are hedge funds expensive?
Hedge funds are commonly deemed to be expensive. This is
because of the historical practice of charging a “2 and 20” fee
structure (a 2% fixed management fee and 20% performance
fee). This has changed somewhat: according to Novare’s 2019
hedge fund survey the most common management fee is now
1% while performance fees are still set around 20% in the main.
By comparison, the February 2021 Corion Report indicates that,
for the top five balanced funds, the average management fee
was 1.05% and two of these had performance fees of 10%.
This suggests that while hedge funds do continue to have
relatively more aggressive performance fee levels, their base
fees are remarkably like traditional funds. It also indicated that
understanding the basis for the performance fee calculation
is especially important for investors considering the use or
performance of hedge funds.
Why have regulators put hedge funds into a different
(regulatory) box?
There are three reasons for regulating any investment vehicle:
firstly, to protect consumers; secondly, to protect the smooth
operation of financial markets; and, finally, to protect the
stability of the financial system. These are compelling reasons
but the creation of a separate class for hedge funds suggests
that they are somehow different to, and riskier than, other types
of investments. Is this perception justified?
Hedge funds can do several things which traditional
investment vehicles cannot. Firstly, they can, and often do, go
short. This allows hedge funds to provide positive returns for
their investors when asset prices are going down, not only when
they are going up. This is a significant advantage over traditional
funds. It is also riskier given that most asset markets have a
positive trend. The second difference is that hedge funds can
use leverage to expose the fund to more risk (and return) than the
initial capital invested. This again creates space for better fund
performance, but also more risk to be managed. Finally, hedge
Should investors use hedge funds?
The answer is hedge funds should be part of any investor’s
consideration set. It is important to note that they are more
complex investment vehicles, which means that their separate
regulatory classification is appropriate and that they need to
be assessed differently to traditional funds. However, they add
value to the financial system, and it is exactly this complexity
that gives them a potential place in investors’ portfolios. Finally,
while their performance fees may be higher, their management
fees are not expensive. Performance
fees are only paid when the hurdle rate
is achieved – so the client is only paying
for performance when it is earned.
In summary then, regulators are
right to flag the additional inherent
complexity of hedge funds. Investors
are losing out, however, if they dismiss
them because they are “too risky” and
“too expensive”. They offer something
different and it is this difference that
both makes them attractive and requires
more attention from investors. Professor Evan Gilbert
www.bluechipdigital.co.za
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