6.4 Major Product Segments
6.4.3 Hedge Funds
Similar to mutual funds, the pooling of investments is the core idea behind hedge funds.
Investors acquire shares in these funds and the funds proceed to invest the pooled assets on the behalf of the investors. The investors’ stake in the portfolio is represented by the NAV of each share. Hedge funds in this sense, operate in the same way as mutual funds. There are however, significant differences between hedge funds and mutual funds.
Hedge funds are subjected to less stringent transparency requirements than mutual funds.
Furthermore, Hedge funds do not advertise to the general public unlike mutual funds and usually have a maximum of 100 investors who are usually high net worth investors. Mutual funds usually make public their investment approach for example, small-cap value orientation, or small-cap momentum orientation, large-cap value orientation, etc., and face the pressure to eschew style drift (the departure from stated investment orientation) whereas hedge fund managers are not obliged to make public their investment strategies. There are also differences in liquidity and compensation structures of hedge funds and mutual funds, whereas hedge funds often implement lock-up periods, i.e., periods within which withdrawal of investments is not allowed and many hedge funds also implement notice of redemption that requires investors to give notices in advance could be weeks or months depending on the fund of the desire to withdraw funds.
Page | 134 Mutual funds do not usually implement such stringent redemption policies therefore making them more liquid than hedge funds. In terms of remuneration, mutual funds also differ from hedge funds in their fee structure. Mutual funds usually set management fees as fixed percentage of assets under management generally between 0.5% and 1.5 annually for a typical equity fund whiles hedge funds usually impose a management fee that ranges from 1% to 2%
of assets under management and an incentive fee set as a percentage (usually 20%) of any investment profits above a given benchmark (Bodie et al., 2014).
The phrase “hedge fund” was coined by sociologist Alfred W. Jones (Ineichen, 2002, Ubide, 2006) and also credited with the establishment of the first hedge fund in 1949, this however has been disputed (Anson, 2006). Alfred Jones described his fund as "hedged", a term that was generally used on Wall Street to portray risk management of investment as a result of changes in capital markets (Lhabitant, 2011).
Due to heavy losses, several hedge funds collapsed in the period of the recession of 1969–70 as well as the 1973–1974 stock market crash. The industry however gained renewed interest in the late 1980s (Ineichen, 2002). In the 1990s, the number of hedge funds grew substantially, this growth was fuelled by the wealth created during bull market of the 1990s (Ubide, 2006).
The renewed interest was as a result of the promise of high returns and the compensation structure adopted by hedge funds that aligned the interest of managers and investors (Nicholas, 2004).
Hedge funds gained worldwide popularity during the first decade of the 21st century and by 2008, the hedge fund industry held $1.93 trillion in AUM (Herbst-Bayliss, 2011). The financial crisis of 2008 however led many hedge fund managers to constrain withdrawals by leading to a decline in their popularity and AUM (Pessin, 2010). Assets under management of hedge funds have grown from $1.45 trillion in 2008 to $2.79 trillion in 2015 (Barclay Hedge, 2016).
By February 2011, institutional investors accounted for 61% of worldwide investments in hedge funds (Williamson, 2011). According to Preqin’s 2016 Global Hedge Fund Report, over 5,000 global institutional investors invested in hedge funds. The hedge fund industry attracted
$71.5 billion new capital inflow with 829 funds launched in 2015 and 625 funds closed in 2015 as well. (Preqin, 2015).
Page | 135 Figure 6.14: Global Hedge Fund Industry: Assets Under Management (AUM)
Source: Barclay Hedge (2016), “Hedge Fund Industry”
www.barclayhedge.com/research/indices/ghs/mum/Hedge_Fund.html
More than 4,800 global institutional investors invested with hedge funds in 2014 representing almost 65 percent of the invested capital of the industry. Overall, total assets under management in 2014 increased by $355 billion (Preqin, 2015). Figure 6.14 illustrates a breakdown of capital invested by institutional investors in hedge funds in 2014.
Regardless of the actions by some public pension funds in the second half of 2014, there was a pervasive over-allocation of funds from the pension funds industry. Public pension plans accounted for about 20 percent of all institutional capital that were invested with hedge funds.
When investments from private pensions are factored in, the number almost doubles. Public pension funds dedicated about 7.8 percent on average of their portfolio to hedge funds as shown in Figure 6.15 (Preqin, 2015).
Page | 136 Figure 6.15: Breakdown of Institutional Investor Capital Invested in Hedge Funds by Investor Type
Source: Preqin (2015: 2)
In South Africa, the financial sector is matured enough to offer hedge funds. Investors in hedge funds in South Africa are mostly funds of funds. From 2006 to 2014, the AuM of South African hedge funds have grown at a CAGR of 16.9% (Figure 6.16) (PwC, 2015). New legislation bringing hedge funds under the regulations of CIS is projected to significantly increase the AuM of hedge funds by making hedge funds which were previously only available to institutional investors, now available to retail investors as well (PwC, 2015).
Page | 137 Figure 6.16: Evolution of AuM of Hedge Funds in South Africa
Source: Adopted from Novare Investment, cited in PwC (2015: 24)