Hedge funds: Performance with reduced volatility

Fear and uncertainty are two keys factors that influence poor decision-making. The field of behavioural finance is dedicated to showing why investment decisions are not always rational.

In the sharp-shock market environment of March 2020, a world hard-hit by Covid-19 resulted in immense volatility on the stock markets. Knee-jerk reactions were incredibly tempting.

“Last year no one knew how long the market decline was going to last. Some people could have decided to cut their losses to save themselves from more pain and disinvested. It would have been the worst decision at the worst time,” says Werner Prinsloo, founder and CIO of X-Chequer boutique alternative investment house in South Africa.

Prinsloo argues that while volatility on its own is not necessarily the evil everyone makes it out to be, its existence influences irrational behaviour and reducing it as much as possible limits the risk of detrimental emotional decision-making that is often associated with extreme portfolio moves.

X-Chequer’s flagship fund is a market-neutral hedge fund. One of its prime tenets is to seek limited directional exposure to the market – equally going long and short intra-sector on stock pairs. In the 15 years since the company was founded, says Prinsloo, the fund has never been down in a calendar year. Using the rolling 12-month average, the worst performance, after fees, at any data point was being down 0.6%.

“Volatility on its own is not a bad thing, but it does create problems like panic. It also pulls the reins on the power of compounding,” says Prinsloo.

Compounding

While many people will claim they understand the impact of compounding and even use the phrase ‘eighth wonder of the world’, Prinsloo does not believe that this is something investors often benefit from in practice.

“I really do wish more people would fully realise the power it has to provide financial freedom,” says Prinsloo.

“If you pick the right products and asset classes and remain invested, the power it gives you over time is astonishing.”

In simple terms, says Prinsloo, compounded returns mean that you begin to earn returns on prior returns, which multiplies your investment at an ever-accelerating rate.

“Take an example. Investing R1 000 today will return R612 at 1% per month over a four-year period. But if you keep that investment, and don’t disinvest, the same amount [R612], notwithstanding the impact of inflation, will be added over only 11 months once you hit year 14 of the investment.”

To obtain the most out of compounding, investments should limit drawdowns (or recoup them as quickly as possible), investors should remain invested as long as possible, and returns should be steady and incremental rather than wild and volatile.

These are objectives that a market-neutral hedge fund can achieve, says Prinsloo.

The price of cutting out volatility

The hedge fund promise is contained right there in the name – it is supposed to hedge you against losses, protecting your investment.

“The original purpose of hedge funds was to provide compounding returns as an alternative to riskier asset classes, but with significantly less volatility; something that can keep pace with equities over time, while protecting the downside in the process,” says Prinsloo.

This sounds appealing and quite noble. However, hedge funds seem to have gained a somewhat tainted reputation – even when people don’t really understand what it is they do.

“Unfortunately, this original purpose has been lost somewhat over the years by the proliferation of high-risk funds, several of which failed spectacularly, that used the wide array of instruments available to them to pile on risk in pursuit of big returns. Like anything in life, there are always the few bad apples that haven’t done what they promised,” says Prinsloo. “If you look at hedge funds over the last 15 years there have been some really good performing ones.”

Historically the fees charged by hedge funds and the managers involved have also been placed in the spotlight. The funds usually charge a management fee combined with a performance fee if a certain benchmark and high-water mark is achieved. They are often associated with higher total expense ratios (TERs) than mutual funds.

“High TERs, for the right reasons, may very well be a much better investment choice than low TER options.

“As an investor in hedge funds you actually want your fund to be expensive, as crazy as that may sound,” says Prinsloo.

Expensive fees in the hedge fund world, when linked to fund performance, means that the fund is doing well and hitting its benchmark of providing you with the required post-fee returns.

“Of course a focus on fees is important, but the focus should be on transparency, rather than fee levels. You can have a cheap fund where you still have bad fees because paying them does not result in the return you were promised. If you were being charged high fees, but you were getting a good return and less volatility, are you going to be unhappy?” asks Prinsloo.

X-Chequer, in fact, closely monitors its TER and gets “uncomfortable” when it drops too much, says Prinsloo. “Because that means we are not delivering the desired returns we aim for.”

Consistent performance

X-Chequer started its market-neutral fund 15 years ago. Since then it has outperformed the JSE’s All Share Index (Alsi), achieving 12% per annum.

“By not having a down year since its inception we have definitely unlocked the power of compounding,” Prinsloo says. “Steady, consistent returns, with low volatility, have helped us to deliver on the promise that hedge funds set out initially.”

After the shock of 2020, he also believes that advisors need to find enhanced risk-adjusted return profiles for their clients.

“This is something hedge funds pride themselves on. Looking at the three years ended 31 May 2021, which covers the 2020 crash, our market-neutral fund yielded 12.13% per annum after fees, in comparison to the Alsi’s 9.98% per annum.

“I think the hedge fund industry is achieving a level of maturity on par with traditional asset classes and is poised for strong growth,” says Prinsloo.

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