Harvesting potential

South Africa's hedge fund market has been hampered by strict limits on the amounts pension funds can invest, but Willem van der Merwe of African Harvest Alternative Investment believes anticipated changes in the rules later this year could give the local hedge fund industry a boost

South Africa's regulator serves as both a friend and an enemy to the country's hedge fund industry. Friend, because its exchange control laws encourage local pension funds and private investors to keep their money in South Africa rather than invest it abroad; enemy, because pension funds are restricted from investing more than a fraction of their capital in hedge funds or funds of funds.

But it has not prevented a budding hedge fund industry from emerging in the country. African Harvest Alternative Investments (AHAI), a Cape Town-based fund management company, for instance, launched two funds of hedge funds in November 2003 - the AHAI Absolute Fund and the AHAI Relative Fund. The Relative Fund has EUR62 million ($9.8 million) in assets under management invested in 10 South African long/short equity hedge funds; the Absolute Fund has EUR48 million in assets across 12 domestic long/short equity funds and fixed-income arbitrage funds.

The Absolute Fund has posted returns of 15.5% over the past 12 months and 23.5% since inception, while the higher-risk Relative Fund has recorded returns of 30.1% over the past 12 months and 47.3% since its launch. While this outperforms the South African consumer price index (excluding mortgage interest), it lags behind the Johannesburg Stock Exchange's All-Share index, which has risen by 63% since the funds' inception.

African Harvest can invest in hedge funds outside South Africa as part of its fund-of-funds offerings. However, it has chosen to focus on domestic hedge funds, primarily because of restrictions on pension funds, which are prohibited from investing more than 15% of their assets offshore. "It is onerous for (pension funds) to track the offshore exposure of the funds they are invested in, so funds tend to prefer specialist asset class products that focus either exclusively on South Africa or exclusively on offshore markets," says Willem van der Merwe, African Harvest's head of risk management.

There are around 50 hedge funds based in South Africa, with around EUR6 billion of assets under management. Of these, van der Merwe says there are only about 25 or 30 large funds, mostly specialising in long/short equity strategies.

The Pension Funds Act limits pension and provident funds from investing more than 2.5% of their assets in hedge funds. But this act is up for revision early next year, and van der Merwe reckons an anticipated widening of the investment limit could kick-start further growth in South Africa's hedge fund market: "Currently, there is a lot of wait-and-see until the regulations come into effect. We expect quite a lot of growth - there is a lot of interest out there."

But the small number of hedge fund managers does have an upside. It means African Harvest is able to conduct comprehensive due diligence and risk monitoring on each manager within the fund of funds. "In South Africa, there are few enough funds that we can study them all in detail," says van der Merwe. "We would like to see one year of relevant hedge fund management experience, and at the very least three years' worth of fund management experience. We find comfort in the record, but sometimes we have to loosen these constraints."

A large proportion of South Africa's economy is export-led, and therefore exposed to currency volatility. The rand weakened by more than 23% between December 2004 and June this year, and was trading at EUR6.65 to the dollar at the end of October. "Significant currency volatility is always a significant market risk factor," says van der Merwe. "We manage overall fund-of-funds risk through manager, strategy and style diversification. To a large degree, we leave the market risk management to the individual hedge fund managers."

But African Harvest is not completely passive when it comes to risk management. "We employ an Advanced Portfolio Technologies (APT) principal component-based risk model that allows us to measure market risk over multiple asset classes," van der Merwe explains. "With this model we can quantify, for example, the currency risk beta, or interest rate risk or any other market-related risk in a fund or the overall fund of funds. In addition to APT, we use a value-at-risk approach as a reality check. Again, we prefer the VAR modelling to be based on underlying holding information instead of some measure of historical fund returns."

Even with the current restrictions on pension fund investment, 85% of African Harvest's assets originate from South African pension funds, with the rest coming from retail investors. However, the country's pension funds have typically preferred to turn to the offshore market when investing in hedge funds. The expected loosening of regulations at the end of this year could go some way to changing that, says van der Merwe. "Since (African Harvest) has focused on the institutional market, it has seen relatively slow growth, because that market has a slower adoption rate for new ideas," he says. "After the regulatory issues are sorted out, we expect institutional investment (onshore) to pick up a bit."

Alexander Campbell