Riding out the storm

Hedge funds, many of which are heavily invested in equities, have proliferated quickly in South Africa over the past few years. How has the recent spate of domestic stock market volatility affected the sector? By Clive Davidson.

The boom in South African hedge funds over the past few years has taken place against the backdrop of an extended bull run in the country's equities market, continuing economic growth and political stability. At the same time, the absence of any specific hedge fund regulation means the industry was open to any entrepreneurial investment managers who thought they could turn a profit in a rising market.

That setting now looks very different. Since hitting a high of 31,531.05 on October 11, the FTSE/JSE Africa All Share Index has spiralled downwards, reaching 25,135.13 by January 23 - a 20% drop in a little over three months. In December, the ruling African National Congress (ANC) was riven by a bitter leadership contest that sparked unease about the political future of the country, while the energy crisis that had been simmering for years boiled over into peak-time power cuts in January, leading to predictions of an economic slowdown. To cap it all, new regulations are due to come into effect in April this year that will impose strict conditions on who can manage hedge funds.

But it is such challenging times that prove the worth of hedge funds and the abilities of their managers. Indeed, returns for the volatile month of January showed hedge fund managers doing what they are supposed to do - protecting capital and outperforming traditional long-only mutual funds. Mindful of a potential economic slowdown, a number of funds are already seeking opportunities in other asset classes and elsewhere in Africa. And their business has been little affected by the new regulations, which have been generally welcomed by the sector.

The South African hedge fund industry grew strongly through 2007, with an estimated R30 billion ($3.9 billion) worth of assets under management by the end of December, up from R18 billion in June 2006. Although investment flows into hedge funds in the second half of 2007 slowed compared with those in the first six months of the year, this is not indicative of a flight away from the sector by investors, say observers.

"The lower inflow in the last six months of 2007 is in line with previous years, where most inflows into hedge funds took place during the first half of a year," says Carla de Waal, risk manager at Cape Town-based investment management and consultancy firm Novare, which undertakes regular surveys of the local hedge fund market.

There are signs that investors will pour even more cash into hedge funds in the first six months of 2008, de Waal adds: "Given the extreme market volatility in the local equity market towards the end of 2007, we expect the trend will continue and local hedge funds might continue to attract substantial inflows in the first half of 2008."

The volatility that beset the country's equity market from October has continued into 2008. But, while local hedge funds have generally recorded lower returns than they had managed in the first half of 2007, many have managed to outperform the FTSE/JSE Africa All Share Index.

"November and December 2007 was the first period of continued draw-downs in the local equity market since 2001, and local hedge funds managed the storm very well," remarks de Waal. "During November, when the FTSE/JSE Africa All Share Index returned -3.2%, local hedge funds on average managed to contain losses to about one-third of that level. In December, the index was down again, returning -4.4%, but local hedge funds on average ended the month flat."

One consequence of the volatile stock market has been to encourage hedge fund managers to diversify their portfolios beyond equities, which has been the focus for most of the funds launched to date. Hedge funds targeting commodities, especially precious metals, are beginning to emerge and there has also been a marked increase in the number of fixed-income funds - although this may be as much down to the introduction of prime brokerage for over-the-counter products as it is to market volatility, suggest some bankers.

"When the hedge fund market started in South Africa, it was predominantly equity because most of the fixed-income products were OTC. For credit rating reasons, banks didn't really want to collateralise them, so no one could really trade effectively as a fixed-income hedge fund," explains Lauren Pearce, Johannesburg-based head of fixed-income prime brokerage at Rand Merchant Bank (RMB). The bank has now introduced a prime brokerage service with credit intermediation, which has gone some way to helping solve the counterparty risk problem for banks, Pearce adds: "With this prime brokerage service, hedge funds have been able to trade additional products in the fixed-income market. With investors looking for different strategies as the money has flowed into the industry, the number of fixed-income hedge funds has expanded."

One of the firms moving into fixed income is Cape Town-based BlueBay Investment Management, which has R1.2 billion under management in its Mayflower multi-strategy fund. After investing in some fixed-income products from late 2006 - with good results, says Richard Pitt, a director of BlueBay - the company launched Flying Cloud, a dedicated fixed-income fund, in October. BlueBay uses RMB's fixed-income prime brokerage service for the fund.

Other managers are launching multi-strategy funds - or reclassifying existing funds as multi-strategy - which allows them greater flexibility in the asset classes they can invest in. BlueBay, for instance, has dabbled in local private equity funds and has made the occasional direct investment. While regulations mean there are some practical limitations to what multi-strategy funds can do (convertible arbitrage, for instance, is off limits), Pitt believes greater flexibility can be rewarding. "If you have the mandate and the willingness to look at things others are not looking at, then there are good odds of finding opportunities compared with just fishing in the same pond as everyone else," he says.

Another trend is for hedge funds to expand their investment universe to include the rest of Africa for diversification and yield enhancement purposes. "This potentially offers very attractive solutions to offshore investors looking for diversified emerging market exposure with solid growth prospects," comments de Waal.

One fund seeking to increase its exposure to the rest of the continent is Johannesburg-based Mazi Visio - but it is doing this by investing in South African companies that are expanding into other parts of Africa. "The financial markets elsewhere in Africa are not as developed as in South Africa. Any company in those markets trades in huge multiples because the supply is limited and outstripped by the demand for those that want exposure to those markets," says Malungelo Zilimbola, director of Johannesburg-based Mazi Capital, which operates the Mazi Visio market-neutral fund in a joint venture with Johannesburg-based Visio Capital Management. "The best way for us to get exposure in Africa is to buy into companies in South Africa that have a good track record and good management and which are growing in those new markets."

Mazi Visio, with around $60 million under management, has bought heavily into mobile-phone company MTN, which is expected to produce more profits from the rest of the continent than it currently does from South Africa within the next two years. Shoprite, Africa's largest food retailer, is another company Mazi Visio holds. "In addition, there is nothing stopping us from going and looking for opportunities for ourselves," says Zilimbola. In fact, Mazi once owned a stake in Nigeria's Guaranty Trust Bank. "We did well out of that," says Zilimbola, adding that he is planning to visit Nigeria to look for further direct investment opportunities.

Meanwhile, South African hedge funds have to cope with new rules that come into effect this year. In August 2007, the South African Financial Services Board (FSB), an independent institution established to oversee the South African non-banking financial services industry, announced specific requirements for the licensing of hedge fund managers. Up until that point, hedge funds were subject to the same rules as long-only investment firms, with no specific recognition of the characteristics of alternative investment funds.

The new regulations specify that hedge fund managers must now meet 'fit and proper' requirements - in particular with regard to minimum education and experience. Managers must have an appropriate degree and three years of experience, or five years of experience and a commitment to obtain a degree within four years. Hedge fund managers were required to submit their applications by the end of February, and the rules come into effect on April 29.

"The fit and proper requirements relate specifically to the strategies the hedge fund manager manages," says Lesley Harvey, partner at Cape Town-based investment management consultancy eComply and board member of the South African branch of the Alternative Investment Managers Association, in which capacity she worked with the FSB on the new regulations. So, if a manager has experience in a long/short equity fund, it won't be relevant to a fixed-income arbitrage fund and vice versa. "Managers will have to demonstrate experience in a particular strategy before they can manage such a fund," adds Harvey.

Opinions are mixed as to whether the new regulations will impede hedge fund growth. Richard Hirsch, who works on the equity derivatives desk at Standard Bank in Johannesburg, believes the regulations are already causing a slowdown in the launch of new funds. Mazi Visio's Zilimbola agrees the new rules could put a brake on expansion: "There will be a big hurdle for people with little experience to set up hedge funds."

Harvey, however, believes the hedge fund market as a whole is unlikely to be reined in by the new rules "It may slow the increase in the number of new managers, but it won't stop the overall growth of the funds," she says.

One outcome of the legislation could be a degree of consolidation in the hedge fund market, where smaller funds run by managers who do not meet the new requirements merge with larger funds, suggests de Waal of Novare. "Where we saw record numbers of new funds springing up every year, we believe managers might now take a bit longer before becoming public, and only after they qualify under the new hedge fund manager regulations," she says.

Despite some trepidation, the regulations have generally been welcomed by all sides of the market. "The regulations won't affect our company and, if anything, they will be positive," says Zilimbola. As hedge funds will be perceived as more tightly regulated, they will attract more institutional investment, particularly from pension funds with their strict fiduciary requirements, he says.

eComply's Harvey agrees: "Until recently, there has been a bit of a shroud around hedge funds and a consequent nervousness - not just locally, but internationally. These new regulations encourage transparency, so hopefully some of the veils will be lifted."

Notwithstanding the possible positive effect of the new regulations, South African hedge funds face a number of uncertainties. On the economic front, the outlook is decidedly mixed. An acrimonious contest in December for the leadership of the ANC, and the success of populist figure Jacob Zuma, have led to some unease about the political direction of the country should he succeed Thabo Mbeki as president. Meanwhile, January saw the power crisis finally reach crunch point, with gold mines forced to close for periods and the government introducing electricity rationing. Balancing this to some degree is the 2010 Fifa World Cup, where preparations to host the event have led to huge investment in infrastructure, such as the development of the Gautrain rapid rail service between OR Tambo Airport (formerly Johannesburg International Airport), Johannesburg and Pretoria. Nevertheless, these uncertainties - and the volatility likely to accompany them - could be good for hedge funds.

"Local investors in the South African equity market have been spoilt by annualised returns in excess of 40% over the past four-and-a-half years," says de Waal. "In such an environment, it is very difficult to make a case for hedge funds that promise capital protection in bear markets but give only half the return of equities in bull markets. Given the recent weakness in the equity market, we might now actually see more interest in hedge funds."

Ian Hamilton, executive chairman of Dubai-based asset administration services provider IDS International, part of Cape Town-based Investment Data Services Group, agrees: "Comparisons of the recent performance of the hedge fund industry to that of the traditional fund industry will illustrate how important hedge funds are for a risk diversified portfolio. The hedge funds came under some criticism in the bull market for, in many instances, underperforming the general indexes. This was through a misunderstanding. Hedge funds are not investments designed to outperform bull markets. Rather, they are funds that provide returns that are either not correlated with traditional markets or prove their worth in volatile or bear markets."

Although hedge fund managers will gain new credibility under the new regulations, restrictions on the marketing of hedge funds to retail clients remain in place. As such, firms must rely on institutional investors and, in particular, pension funds. But whether the country's pension schemes will be convinced of the value of hedge funds is still an open question.

"If the equity environment does change - and you can make a case that is potentially starting to happen already - and as long as hedge funds deliver returns, there should be an opportunity for quite big allocations," says BlueBay's Pitt.

The FTSE/JSE Africa All Share Index climbed by approximately 6% between February 1, 2007 and January 31, 2008. In comparison, BlueBay's Mayflower fund was up by around 24% over the same period. Viewed from this perspective, hedge fund investment starts to look attractive. And if the market falls and hedge funds can still make positive returns - or, at the very least, outperform the benchmark - it becomes particularly attractive to pension fund investors. "But I don't know how motivated the big pension funds are to having exposure to hedge funds, and that is where the money will have to come from because we can't market so we can't get retail money," says Pitt.

South Africa remains a country of unbridled optimism and energy, while wrestling with enormous social and economic problems. The current bumpy conditions might be just what hedge funds need to prove the value of their contribution to the country's exciting but uncertain future.