A sense of puzzlement surrounds the topic of hedge funds. Some investors are hesitant to invest because they find the concept foreign, preferring instruments with which they are more familiar. Others claim insight, but are quick to warn against the dangers of Hedge Funds, describing them as complex, high-risk investments that expose the investor to almost infinite downside risks in the pursuit of optimistic returns. Neither of these views are uncommon, although far from the truth. It is therefore important that these rumours and their origins are addressed and that investors are educated regarding the true nature of hedge funds.

1. December 2017
A sense of puzzlement surrounds the topic of hedge funds. Some investors are hesitant to invest because they
find the concept foreign, preferring instruments with which they are more familiar. Others claim insight, but
are quick to warn against the dangers of Hedge Funds, describing them as complex, high-risk investments that
expose the investor to almost infinite downside risks in the pursuit of optimistic returns. Neither of these
views are uncommon, although far from the truth. It is therefore important that these rumours and their
origins are addressed and that investors are educated regarding the true nature of hedge funds.
What is a Hedge Fund?
Hedge Funds are in many ways similar to traditional unit trusts where investors’ money is pooled into
regulated structures and collectively used to buy assets such as cash, bonds, property and equities. A defining
characteristic of a hedge funds is the manager’s investment freedom, not having to tie his performance to that
of a reference benchmark such as a market index or peer group managers. With this, hedge funds have greater
flexibility in the instruments and strategies used to create a diversified portfolio. The use of short selling and
leverage to reduce market correlation, is also very typical.
Since 2015 South African Hedge Funds have been governed
by the Collective Investment Schemes Control Act (CISCA),
the same legislation that governs local unit trusts. This
further increased the protection of investors that might
not have the industry knowledge to fully consider
investment risks involved.
The True Nature of Hedge Funds
Higher levels of flexibility in the choice of strategy
encourages the creation of funds that are a very beneficial
addition to an investor’s overall portfolio. Unfortunately,
there have been some hedge funds with atypical risk
appetites that used the flexibility to expose investors to
very risky investments resulting in large capital losses, and
a smearing of hedge funds’ reputation with the ensuing
bad press. It must be emphasized that these limited
examples did not occur within the South African regulated
environment. The true nature of hedge funds, is typically
quite the opposite.
What is Short Selling?
Short selling a is mechanism used to
express a bearish view, the expectation
that the price will decline. Simply put it
works on the conventional investment
principle of “buying low” and “selling
high”, the key difference is the
sequence of these transactions. In a
traditional long transaction, to express
a bullish view, the buy transaction
precedes the sell transaction, short
selling reverses this process by initially
selling the asset with the intention to
buy in the future at a lower price.
Are All Hedge Funds really that Risky?
Elmien Wagenaar & Kobus Jansen van Vuuren

2. December 2017
Risk Assessment of Hedge Funds
Graph 1, shows the annualised 5-year risk (as measured by volatility) and return of all South African Hedge
Funds over the 5-year period ending November 2017 in blue. The annualised risk and return of the JSE All
Share Index TR (JSE) and the All Bond Index (ALBI), over the same period, are represented by the black dot and
the red square respectively. The shaded portion of the graph shows that the vast majority (88.54%) of South
African Hedge Funds generated returns at a lower risk level than the JSE. This serves as a first proof that hedge
funds are not, by a long shot, the high-risk instruments that some believe.
Bonds are instruments traditionally used in portfolios to decrease overall risk. It is therefore worth comparing
hedge funds to these as well. The ALBI, as can be expected, has a 5-year annualised risk and annualised return
lower than that of the JSE. The more interesting observation is how hedge fund outcomes compare to that of
bonds. Of the hedge fund, 65.63% were able to outperform ALBI returns at a lower volatility (shown
highlighted (red) on graph). From this the following can be concluded.
Downside Risk Analysis
To further support the statement above, it is worth considering an additional risk measure to ensure a deeper
level of comfort with the risk involved. To investigate the downside risk of hedge funds, a worst-case scenario
analysis is done by only considering the down months of equity and bonds respectively, over the 5 years
leading up to November 2017. Graph 2 shows the cumulative returns of South African hedge funds over only
the months in which the JSE had negative returns. From the graph it can be seen that 99% of hedge funds
outperformed equities over these difficult months, a testament to the downside protection hedge funds can
provide. Even more noteworthy is the fact that over 50% of these managed to generate a positive return,
implying an outperformance of the JSE by at least 40%.
The right selection of hedge funds is able to have the same risk reducing effect on a
portfolio as the traditional inclusion of bonds, while sacrificing less returns.
0%
5%
10%
15%
20%
25%
30%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
Returnpa
Risk pa
Graph 1: South African Hedge Funds 5-year Annualised Risk and Return
(Period ending November 2017)
All ZAR Hedge Funds Outperformance of ALBI at lower Volatility All Bond Index (ALBI) JSE All Share TR
Source: Morningstar, HedgeNews Africa

3. December 2017
Similarly, Graph 3 considers hedge funds’ cumulative returns over only the months in which the ALBI was
down. It can be seen that the vast majority of hedge funds were able to generated positive returns while
bonds were down.
Conclusion
Hedge Funds offer a lower volatility than both the JSE and ALBI, while also providing very effective downside
protection, playing an important risk reduction role in an overall portfolio while generating outstanding
returns. An additional level of risk reduction can be achieved by investing in a Fund of Hedge Funds, these
ensure expert due diligence as well as diversification across asset classes and manager strategy.
Disclaimer
The RCIS Think Growth QI Hedge Fund is managed by THINK.CAPITAL Investment Management Proprietary Limited in terms of a discretionary mandate. THINK.CAPITAL is an
authorised financial services provider (FSP 46714) in terms of the FAIS Act. This document has been compiled for information purposes only. It is provided in good faith and has been
derived from sources believed to be reliable and accurate. No representation or warranty, express or implied, is made in relation to the accuracy or completeness of this information. It
does not take into account the needs or circumstances of any person or constitute advice of any kind. It is not an offer to sell or an invitation to invest. Past investment performance is
not a guarantee or indicative of future performance. Returns are subject to fluctuation and may be volatile. Returns are net of costs and for a particular fee class. Collective Investment
Schemes are generally medium- to long-term investments. An investor may not get back the full amount invested. No responsibility or liability is accepted by THINK.CAPITAL, its
subsidiaries and its associated companies and/or the directors, employees or agents of THINK.CAPITAL for any loss arising from the use of this information. It is the investor’s
responsibility to inform him or herself of and comply with regulations and applicable laws in the relevant jurisdiction in which they operate. The RCIS THINK Growth QI Hedge Fund is a
collective investment scheme regulated by the Financial Services Board.
-50%
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-10%
0%
10%
20%
30%
40%
50%
Graph 2: Cumulative Return of SA Hedge
Funds over JSE Down-Months
JSE ALBI
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0%
10%
20%
30%
40%
50%
Graph 3: Cumulative Return of SA
Hedge Funds over ALBI Down-Months
ALBI JSESouth African Hedge Funds South African Hedge Funds
Source: Morningstar, HedgeNews Africa