Giving clarity

South Africa's hedge fund industry has developed at a breakneck pace, with assets under management more than doubling last year. While supervisors around the globe ponder how to regulate the hedge fund sector, South Africa's growth has been underpinned by an industry commitment to transparency and risk management. Clive Davidson reports

The South African hedge fund market is experiencing rapid growth. In the 12 months to June 2006, around 30 new funds entered the market and the total amount of assets under management more than doubled to R18 billion ($2.5 billion). One of the reasons for this growth has been the unusual degree of transparency and risk management the industry offers. This has encouraged institutional investors to allocate an increasing proportion of their portfolios to hedge funds. It has also allowed the sector to expand in the absence of regulation, and is part of industry efforts to persuade financial supervisors that when they do introduce legislation, as is expected this year, the regulations focus on structural and tax issues related to hedge funds, and do not constrain the strategies they might use.

Cape Town-based investment management and consultancy firm Novare Investments launched the Mayibentsha fund of funds in March 2003. It uses proprietary methodologies and models to select the funds, which at the moment number 18, and to monitor their exposure and performance.

"We look at all the strategies that are available, but there is not a wide variety," says Carla de Waal, risk manager at Novare. The company undertakes an annual survey of the South African hedge fund market (from which the figures above are taken). Currently, there are around 120 hedge funds, and approximately 80% of their assets are held in equity long/short or market-neutral strategies. There has been an increase in so-called multi-strategies, where funds use a wider universe of instruments such as commodities - although the investment strategy remains long/short or market-neutral. There are a handful each of fixed-income long/short and fixed-income arbitrage funds, but very few macro and other more exotic strategies, largely because the market doesn't offer suitable instruments for these approaches yet, says de Waal.

"Because such a big proportion of South African hedge funds are playing in the small- and mid-cap space, they have to be very aware of liquidity risk when constructing their portfolios," adds de Waal.

Novare has a number of controls it applies when constructing and maintaining its fund of funds - for instance, the portfolio must comprise more than eight hedge funds at all times and no one firm can make up more than 25% of the total fund. The overall fund also cannot be overexposed to illiquid securities. Once a hedge fund is taken into the fund of funds, Novare monitors particularly for style drift - where a fund strays from the strategy that it declared in its mandate. Most hedge funds' assets come through funds of funds such as Mayibentsha, which will apply a similar level of monitoring. However, this is just one layer of scrutiny to which South African hedge funds are subject.

Independent

Unlike South African asset managers and many hedge funds elsewhere, almost all South African hedge funds use an independent administrator. These organisations cover the processing of transactions through to the calculation of net asset values, accounting, payments, and reporting to investors, fund managers and the funds' governance structures.

"The administrator has a fiduciary responsibility to the end investor and ensures the underlying funds are valued using recognised and accepted industry sources," says Veit Schuhen, head of alternative funds services at Cape Town-based fund administrator Finsource, which has 21 South African hedge funds under administration (the company also has more than 80 clients outside South Africa). "Administrators are required to utilise agreed upon and independently audited accounting practices and instrument valuations, and ensure that prices and performance are not inflated." Independent administration also provides checks against potential fraudulent activities at the fund manager, adds Schuhen.

Investment Data Services (IDS) has the lion's share of the administration market, servicing around 100 South African hedge funds (its international services are based in Dubai). The company has grown rapidly from its launch in May 2003, and now employs more than 50 people. But its growth and dominance has led to concerns about concentration risk in terms of one infrastructure provider servicing a large proportion of the market. The concerns are raised by the company itself, and it has taken the unusual step of closing its business to new clients.

"The rationale for this decision is that the growth in our service should never be to such an extent that our capacity was tested to the limit, which could result in service decline," says Ian Hamilton, executive chairman of IDS International. "We train internally, and as such there is a need for staff to mature. We also do want to have competitors to be able to benchmark our services. These sound like lofty ideals, but at the same time we believe in sustainable and good business practice. Our clients are loyal and they themselves are growing."

IDS' move is very much in keeping with an attitude of self-regulation and an image of sustainability and good business practice that the industry is keen to foster. There is also a desire to avoid any blow-ups that might stall or derail growth or invite the South African Financial Services Board (FSB) to be prescriptive when it introduces regulation.

At present, hedge funds fall outside South Africa's Collective Investment Schemes Act, which covers conventional asset management products. This legislation does not allow for short selling or leverage, and puts restrictions on holdings in derivatives and certain other practices that hedge funds favour. To get around this, hedge funds generally set up as limited liability partnerships, corporates or trusts, and only take money from institutional investors.

While hedge funds' business has been restricted to the institutional market and their assets under management are relatively small - still less than 0.07% of the capitalisation of the Johannesburg Stock Exchange (JSE), according to Novare - the FSB has tolerated hedge funds' activities. But there remain a number of grey areas, particularly around the structure of hedge funds and tax treatment. Furthermore, hedge funds cannot market to retail customers. As such, virtually everyone seems to agree that the status quo is unsatisfactory and cannot persist indefinitely.

"Hedge funds don't fit neatly into the current investment legislation, so if they were to be tested [in court due to a contested event] there might be unfavourable outcomes. Hedge funds want clarity on [legal] structures," says Warren Chapman, director of Johannesburg-based prime broker Peregrine Securities. "They also want tax certainty in order to be able to take investors' money as efficiently as possible, but they don't want the regulator to tell them how to manage that money."

Meanwhile, other groups such as unit trust managers are wary of regulation that might be intended for hedge funds, but might unwittingly catch and restrict them. "So it's complicated, and getting agreement from all parties - investors, hedge funds, tax authorities and regulators - requires a fine balance, and one-size-that-fits-all legislation has proved elusive over the past decade," adds Chapman.

Peregrine Securities, whose parent company also has a joint venture fund of funds with Johannesburg multi-manager Investment Solutions called Caveo Fund Solutions, is one of a handful of prime brokers active in the South African market. Others include Deutsche Securities (the securities services arm of Deutsche Bank), Investec Securities (the securities services arm of South African bank Investec), and more recent entrant Cadiz, a Cape Town-based asset manager and services company that also owns two hedge funds - Cadiz Sapphire Fund and Cadiz Malachite Fund. In addition to execution, clearing and settlement, the prime brokers offer risk management services such as value-at-risk and liquidity risk calculations, performance measurement and limits monitoring.

Isabella Burke, co-head of prime broking at Investec says: "As a prime broker, we have to monitor our hedge fund clients' risk very closely like we do our own internal dealing desks. In terms of operational risks, we leverage the whole of Investec's operational area to clear and provide custody for our hedge fund clients." For its platform, Investec uses FundManager, a leading specialist hedge fund middle- and back-office system supplied by Paris-based IT services provider Linedata.

Peregrine, meanwhile, has a proprietary platform for its prime broking service with standard risk management functions, and additionally offers bespoke risk services for hedge funds that might be using more complex instruments or strategies. Like the other prime brokers, it will also, with the permission of the hedge fund and its investors, pass portfolio information on to specialist risk consultancy firms, of which Cape Town-based RisCura is the major player in the country.

"The South African hedge fund industry is fairly young and, in this mainly self-regulated environment, it is crucial to provide investors and fund managers with a proper level of protection against systemic risk inherent within hedge fund activity," says Jarred Glansbeek, founder and chief executive of RisCura. His company provides risk and performance measures to the funds themselves, and publishes risk reports for their investors. It also advises investors looking for alternative investments, and helps funds of funds create their portfolios.

"Our business is built on the independent manipulation of information, which is fed into our systems," says Glansbeek. "A large part of hedge funds' willingness to provide information relates to their comfort with us and their need to allow clients to manage their portfolios properly without giving away their positions." Hedge fund managers understand the role RisCura plays in the market, and that it will not disclose sensitive information to the end investor. "The level of reporting to funds of hedge funds and to end investors is determined by the hedge funds themselves. When we give a general assessment, clients don't see the names of the funds - they can be presented just as numbers," adds Glansbeek.

Cape Town-based Trident Capital, which has R3 billion of assets under management, including a hedge fund with R125 million in assets, outsources its administration to Peregrine Holdings, uses prime broker services and has an in-house installed risk management system - the APT System from New York-based investment technology provider Advanced Portfolio Technologies. Nevertheless, it still uses RisCura's services. "All my position data goes to RisCura - they see every trade I do," says Kimon Boyiatjis, founder and managing director of Trident. "We understand the concepts of transparency and risk and what it means to have style drift and the need to avoid it, and to ensure that we do what we have told our clients we are going to do."

Because most of the people currently running South African hedge funds come from traditional asset management backgrounds, and because much of the money that is invested goes through funds of funds that are also staffed by people used to traditional asset management regimes, there is a general acceptance of the need for transparency and compliance. "So I am happy to let someone else say that we are within our risk budget and that our limits are what we say they are," adds Boyiatjis.

In addition to the above measures, the South African market boasts still further levels of transparency and risk monitoring, says Peregrine Securities' Chapman. The country still operates exchange controls, so assets cannot flow easily in and out of the country. (However, regulation will probably open up the market to foreign hedge funds, while local hedge funds are looking to offshore vehicles that will enable them to attract foreign investment.) The local industry is also still rather small, so everyone knows one another and more or less what each other is up to, which provides some informal risk scrutiny. And then there is the JSE, which operates a sophisticated market surveillance regime that can check the capital adequacy of member firms, such as the prime brokers.

"Because we have a Big Brother looking out for compliance issues and ensuring that the providers of credit, such as prime brokers, have sufficient capital and resources to manage their level of business, it allows investors and fund managers to transact more easily," says Chapman.

Expectations

Everyone expects the hedge fund industry to continue to grow in the coming year, perhaps at an even faster rate. "An average of R500 million a month flowed into hedge funds in 2006 from pension funds," says RisCura's Glansbeek. "This year, we expect a lot of smaller pension funds to start allocating to alternatives, especially when they see how the returns compare with cash and bonds."

Novare also expects there will be more innovation among funds in terms of strategies. One fund of funds, which did not want to be identified, is incubating new funds with an emphasis on encouraging alternative strategies, such as corporate structure funds, company merger arbitrage and funds that exploit the growth of private equity activity in the country. This is also likely to encourage the growth of the market.

But for all its levels of transparency and risk management, the South African hedge fund industry is not necessarily immune to potential problems. There could still be something of a shake-out in the market, particularly given the fact that the Johannesburg Stock Exchange has had a bull run since April 2003. "Most hedge funds haven't experienced a bear market yet - we have still to see where the skill really is," says Novare's de Waal.

Finsource's Schuhen agrees: "The recent bull market has seen a plethora of new entrants into the market, who are all performing quite well. With an expected slowdown in the market imminent, only the really talented will survive."

RisCura's Glansbeek notes that South Africa has benefited in coming relatively late to hedge funds and being able to learn from other countries' experience, not least in ensuring that there are sufficient checks and balances in place. But while that might reduce risk, it does not necessarily limit it.

"As far as I know, there are only one or two managers that don't have independent risk services," says Glansbeek. "In general, fund administration is all external. The South African market has limited opportunities and styles of fund management, and people don't gear that much - it is therefore a less risky environment. Also, a lot of our hedge fund managers have their own wealth tied up in their funds. All these factors are positive in the great risk management debate. But that doesn't mean we won't have a blowout."

In the past four years, there has just been one rough patch for hedge funds - a correction in the JSE in May and June 2006. "But this was hardly a catastrophe," says Glansbeek. "Hence, I believe the test is yet to occur, whether it be in terms of systems, managers and their investments, fraud or in fund-of-funds processes."

When the test comes, it will reveal just how resilient all the levels of transparency and risk management have really made the South African hedge fund industry.