The South African Hedge Fund Industry
Winter 2016The South AfricanHedge fund industry:An ever evolving landscapeKey topics How is the South African Hedgefund industry changing? How are hedge fundsdifferentiated from othercollective investment schemes? How are MANCO’s benefiting fromthe new regulations?In South Africa hedge funds have gone through various regulatory changesover the last ten years culminating in the most comprehensive changes in2015 when hedge funds were finally regulated as a product. Initially, there wasno product specific regulation for hedge funds. Only the hedge fundmanager was regulated as a discretionary financial services provider.On 29 August 2007, amidst growing concernabout the perceived lack of transparency inthe South African hedge fund industry, theFSB published its long-awaited regulations(the ‘Hedge Fund Regulations’) governingSouth Africa’s hedge fund industry. Broadlyspeaking, the Hedge Fund Regulationsestablished certain ‘fit and properrequirements’ for hedge fund managers,introduced the procedures which hedgefund managers are required to follow inorder to obtain authorisation to act as suchand the created of a Code of Conduct forhedge fund managers.The Fit and Proper Requirements made itobligatory for anyone managing a hedgefund to apply to the FSB for a Category IIAfinancial services provider licence. Category8STAY CONNECTED / HEDGEIIA financial services providers are requiredto have a track record of managing particularhedge fund strategies and are required toadequately demonstrate knowledge, skilland competency in managing all instrumentsand asset classes comprising a hedge fundportfolio as optimised by and in conjunctionwith the requisite hedge fund strategiesemployed from time to time. In addition, anapplicant for a licence to act as a CategoryIIA financial service provider, as well as anykey individual of such applicant, is requiredto display certain character qualities such ashonesty and integrity and to meet certainacademic requirements. The Code ofConduct is significant in that, for the firsttime in South African law, the definition of ahedge fund was provided as hedge fundmeans a portfolio which uses any strategy or
“The most prominent change is theintroduction of two types of hedge funds,being the Retail Investor Hedge Fund (RIHF)and the Qualified Investor Hedge Fund (QIF)”.takes any position which could result in theportfolio incurring losses greater than itsaggregate market value at any point in time,and which strategies or positions include, butare not limited to, leverage or net shortpositions.Following the financial crisis in 2008 andSouth Africa’s G20 commitments, the SouthAfrican National Treasury and the FinancialServices Board (FSB) released a frameworkfor regulating hedge funds in South Africa on13 September 2012. The regulators took theindustry comments into account and on 16April 2014 and published the new hedge fundRegulations (the New Regulations) whichwere effected through the CollectiveInvestment Scheme Control Act (CISCA).On 25 February 2015 the Minister declaredhedge funds to be collective investmentschemes in terms of section 63 of CISCA.On 6 March 2015 the New Regulations werepublished to be effective from 1 April 2015.Hedge fund managers were given six monthsfrom that date to register their managementcompanies (commonly referred to as“MANCO”) and their hedge fund portfolioswith the collective investment schemeRegistrar (CIS Registrar) and twelve monthsto comply with all the new investorprotection requirements that would beapplicable to hedge funds as collectiveinvestment schemes.The most prominent change is theintroduction of two types of hedge funds,being the Retail Investor Hedge Fund (RIHF)and the Qualified Investor Hedge Fund (QIF).A qualified investor will be an investor thatcommits a minimum of R 1 million and thathas illustrated that he understands theworkings and risks of hedge funds. The NewRegulations make South Africa the firstcountry in the world to regulate hedge funds(as a product) to such a large extent.Europe’s Undertaking for CollectiveInvestment of Transferable Securities(UCITS) is also a very comprehensiveEuropean Commission framework but thedifference is that UCITS applies to mutualfunds generally and not just to hedge funds.That is ironic considering that, in my view,South African hedge funds have been themost self-regulated funds in the worldand have largely employed the adequaterisk management processes and checksand balances that a lot of internationalhedge funds did not have prior to thefinancial crisis.Although hedge funds are now collectiveinvestment schemes, they are given distincttreatment from other unit trusts regulatedby CISCA in that as a designated schemethey are permitted to enter into certaintransactions and employ certain strategiesthat unit trust may not enter into. Althoughthere are marked differences betweenhedge funds and unit trusts, the fact thathedge funds are now regulated under CISCAhas given investors greater confidence inthat CISCA has a long history of regulatingunit trusts in South Africa and various CISCAprovisions are now applicable in theenforcement of hedge funds. To note a few: The marketing and solicitation rules thatapply to unit trusts, as set out in BoardNotice 92 of 2014 apply to hedge funds.While previously the Association ofSavings Investment South Africa (ASISA)monitored advertising of collectiveinvestment scheme investments throughthe code of conduct applicable to theirmembers (“ASISA Code”), all advertisingmaterial, fund fact sheets, applicationforms and minimum disclosuredocuments ( the equivalent of the KIDdocument under UCITS) must now besubmitted to the FSB for review. Whereas previously, hedge funds enjoyedfreedom of contract to agree most issuescontractually with investors, goingforward an array of matters will beregulated. These include repurchase/redemption obligations; requirementsaround the posting and receipt ofcollateral; requirements in relation toderivative instrument counterparties;requirements in relation to valuation andpricing; disclosure and reportingrequirements to investors; and prudentialinvestment requirements for retail hedgefunds; operators of foreign hedge funds canmarket their hedge funds to South Africanclients by obtaining authorisation throughSection 65 of CISCA;STAY CONNECTED / HEDGE9
Winter 2016Hedge funds: It’s complexHead fundmanagerMANCO any contravention of the New Regulationsshall be punishable or enforced in termsof CISCA, with the maximum liability beinga fine not exceeding R10 million or toimprisonment for period not exceeding10 years, or to both.Hedge funds may be structured as trustarrangements formed under CISCA or aslimited liability partnerships. Hedge fundshoused in other structures, such as bewindor vesting trusts had to be restructuredbefore 31 March 2016.The New Regulations also make itpermissible for MANCOS to establishplatforms that host different portfolioswhich are administered independently ofeach other. Most hedge fund managershave opted for platforms as opposed toestablishing and licensing their own MANCOsdue to the cost of establishing a MANCOunder the New Regulations. One of the morepractical consequences of the newRegulations is that it has become expensiveand administratively burdensome for hedgefund managers to incorporate a MANCO. Byway of example, the board of directors of theMANCO must be comprised of at least fourdirectors, of which 50% must be nonexecutive directors and the majority of thenon-executive directors must beindependent. The pool of these independentdirectors is limited considering that theboard must be comprised of individuals whocan demonstrate collective investmentscheme, legal and accounting expertise.The MANCO will need to submit itsmemorandum of incorporation to the CISRegistrar. The CIS Registrar requires thatsuch memorandum of incorporation contain10STAY CONNECTED / HEDGEAdministratorsPrime brokersRisk managersComplianceofficersMichael DenengaDirectorThipaDenengae: michael@thipadenenga.comw: thipadenenga.comrestrictive conditions and that the MANCObe a “ring-fenced” company. More critically,the MANCO will have to meet certain capitalrequirements and must provide annualfinancial statements in respect of theprevious three years. The MANCO will berequired to have necessary control,compliance and risk managementprocedures in place, including, for example,documentation relating to businessprocesses, policies and controls, a complaintresolution procedure and a businesscontinuity plan.Under the platform structure, the hedgefund manager will be appointed as adiscretionary financial services provider bythe MANCO in terms of an InvestmentManagement Agreement between theparties. Most of the MANCOS that have beenappointed have chosen the trust structurebecause this is the structure that housedtraditional collective investment schemesand from a system and operationalperspective it is more efficient for theplatforms to maintain this structure.The hedge fund managers still require theCategory II Licence. In addition it is importantto remember that hedge funds are regulatedby other pieces of legislation that affectstheir business operations. A hedge fund is acomplex creature that comprises of thehedge fund manager, the MANCO, theadministrators, prime brokers, risk managersand compliance officers. Legislation thatregulates the prime brokers such as theFinancial Markets Act and the Rules of theJSE Limited must also be taken into accountin determining the full spectrum of hedgefund compliance.In summaryThe hedge fund industry is hoping that theincreased transparency and governancerequirements will lead to increased investorconfidence in the hedge fund industry as theNew Regulations become more settledand better understood.
A unique alphaopportunityKey topics What are the results now globalearnings growth is set to align withglobal economic growth? How are South African AssetManagers benefiting fromstructural inefficiencies? Will alpha opportunities everbecome a reality?Shortly after the global financial crisis of 2008, manyprominent market commentators were forecastinga transition to a new low return world. With hindsight,it appears that these predictions were premature,with risk assets rallying significantly from their March2009 lows.The S&P500 has produced an annualisedreturn of 15.1% from those lows and its priceearnings ratio has more than doubled overthe same period, despite anaemic globalgrowth. However, with that “re-rating equityrally” largely behind us, it would appear thatthe sages of 2009 may now be more correctthan they were back then, as global earningsgrowth looks set to align with globaleconomic growth.As a result investors have re-calibrated theirreturn expectations which has led to amassive focus on the value of activeinvestment management. This scrutiny isepitomised by the discussions around globalhedge fund fees, as nominal returns fromglobal hedge funds have fallen. Thechallenge for active management, is anincreasingly competitive landscape, leadingto an ever greater reliance on market beta asSTAY CONNECTED / HEDGE11
Winter 2016the primary driver of returns. This may wellalso be the case for hedge funds which arefocussed on highly developed andcompetitive markets. Funds which are ableto benefit from structural inefficiencies inemerging markets, do not face the samechallenges, but then investors typically haveto accept a trade-off of potentially higheralpha, at the expense of institutionalsoundness, regulatory certainty and financialmarket maturity.Against this backdrop South Africa presentsan appealing potential investmentdestination. According to the WorldEconomic Forum’s Global CompetitivenessStudy, South Africa ranks exceptionally highin the categories which are of mostimportance to a financial market investors.With regard to its institutions, South Africaranks first globally in relation to the strengthof its auditing and financial reportingstandards. It ranks in the top 3 for theefficacy and accountability of corporateboards, as well as the protection of minorityshareholders’ rights. From a financial12STAY CONNECTED / HEDGE“The South African stock marketcapitalisation is over 2.5 times the size of itsGDP, as compared to the USA which has acombined stock market capitalisation of 1.5times GDP, and most other emergingeconomies at well less than 1 times GDP”.markets perspective, it ranks number oneand two respectively for the ability to financethrough the local equity market and theregulation of the securities exchange. It alsoranks in the top 12 with regards to thesoundness of its banks and the financialmarket development. Therefore,notwithstanding South Africa’s overallranking of 49th amongst 140 countries in thestudy, it ranks higher than most developednations, including the USA in a number of thesubcategories which relate to investing inlisted securities.Further to this context, South African assetmanagers have the benefit of structuralinefficiencies within the domestic savingspool. The South African stock marketcapitalisation is over 2.5 times the size of itsGDP, as compared to the USA which has acombined stock market capitalisation of 1.5times GDP, and most other emerging
economies at well less than 1 times GDP.Interestingly, only roughly 35% of therevenue of stocks listed in South Africa isderived from the local economy, with thebalance of revenues derived from acombination of global resources (25%),global developed market defensive (15%)and global consumer growth (25%) stocks.This structure means that investors in theSouth African market have the ability toaccess many global macro themes in a rangeof South African listed stocks trading in avery well-regulated and mature financialmarkets infrastructure. The question shouldthen be asked; “are there any structuralimpediments which result in inefficienciesfrom which alpha can be sustainablyderived”. The answer once again is aresounding “yes”. Of the approximately 850billion in savings assets (pension,insurance and mutual funds, according tothe SA Reserve Bank), roughly 90% ismanaged by the seven largest institutionalmoney managers. This leads to a degree oflethargy in the market as these large pools ofcapital fight portfolio inertia due to theirinability to move quickly as the marketenvironment changes. Furthermore, justunder 1% of that entire asset pool is currentlyinvested in hedge funds in South Africa,creating an environment in which flexibleand nimble hedge fund managers are stillable to consistently produce alpha fortheir investors.This story is borne out in the both thenominal returns achieved and the returnsrelative to the S&P500 and global hedgefund peers. According to Bloomberg, theHFRX Macro Multi Strategy Index hasexhibited an annualised return of 2.38%, onvolatility of 4.07% (Sharpe ratio of 0.5) with aBeta to the S&P500 of 0.21, since September2010. Over the same period the HFRX EquityHedge Index has produced an annualisedreturn of 0.15%, on volatility of 6.54% (Sharperatio of -0.03) with a Beta of 0.45, while theS&P has produced 14.4% annualised returnon volatility of 12.14%, giving it a Sharpe ratioof 1.16. Over the same period South Africanhedge fund managers have managed a rangeof different hedge fund strategies focussedon the South Africa market. In order toprovide a flavour of the success in doing so,I’ve selected two strategies to compare tothe global universe, with returns fully hedgedto ensure that US Dollar investors have zerolocal currency exposure (roughly negatingthe interest rate differential). Thesestrategies have not been the top performingmarket create opportunities for talentedhedge fund managers to sustainably extractalpha from the local market, while the marketinfrastructure ranks very favourably relativeto developed markets. South Africa thusprovides a unique alpha opportunity forinvestors who are unwilling to assume theinstitutional and regulatory risk associatedwith a typical emerging market.Bradley AnthonyChief Investment Officer –Fairtree Capitale: bradleya@fairtree.comw: fairtree.comin the South African hedge fund market, butrepresent an above median return relative tothe entire universe. The returns have beensubstantially better than the global indices.One Multi Strategy Fund produced thefollowing returns in US Dollars; an annualisedreturn of 18.5% on volatility of 14.49%(Sharpe ratio of 1.25) with Beta to theS&P500 of 0.13, which compares favourablyto both the HFRX Macro Multi Strategy Indexand the S&P500. Another Equity Long Shortstrategy returned 19.94% annualised, onvolatility of 13.61% (Sharpe ratio of 1.44), witha Beta to the market of 0.02, whichcompares very favourably to the HFRXEquity Hedge Index and the S&P500.The search for elusive alpha is becomingincreasingly harder, and as expectednominal returns from equity markets adjustlower, the ability to produce differentiatedalpha will become more sought after.Investors’ attention on the value-add ofactive management and reticence to payactive fund management fees to hedge fundmanagers who essentially provide betareturns is understandable. Structuralinefficiencies in the South African savingsSTAY CONNECTED / HEDGE13
Winter 2016South Africa:blazing a trail for hedge fundsKey topics How do QIFs and RIFs differ andwhat are they designed for? Why do investors in Europe andthe US see South Africa hedgefunds as an interestingproposition? What does the future hold for theSouth African hedge fund industry?South Africa now has a regulatedsetting for hedge funds – both atmanager and product level, giving itone of the world’s most advancedoperating environments.The industry is hopeful that this will bring anincrease in assets after a multi-year periodwhere growth has been largely organic, ratherthan as a result of new inflows. With currentassets under management in hedge fundstrategies at around R70 billion (US 5billion), the hope is that new types ofinvestors will be attracted byregulated products.The industry has in 2016 been transitioningportfolios into regulated structures.Qualified investor funds (QIFs) are verymuch the same type of product that theindustry has always offered – but withgreater oversight. Designed for sophisticatedinvestors or institutions, they can use higherleverage limits and more unconstrained14STAY CONNECTED / HEDGEmandates in pursuit of higher returns. Retailinvestor funds (RIFs) are designed to cater toa wider set of investors, with somesimilarities to UCITS hedge funds in Europe.They can be accessed via smaller monthlycontributions rather than big lump sums, andthey have various other mandate constraintsincluding lower levels of leverage.Yes, funds must now meet the requirementsof a complex and arduous operatingenvironment. But it is one that the industryhas largely welcomed as it legitimises theefforts of talented managers before a muchwider audience, putting them on an equalfooting with the long-only world.Investors in South African hedge funds canbe assured of the highest levels of oversight,coupled with talented and skilled managerswho have strong track records.International allocators have hailed the newregulatory environment. For investors sittingin Europe or the US, the due diligence
Gwyneth RobertsEditor, HedgeNews Africae: gwyneth.roberts@mac.comw: hedgenewsafrica.comprocess for an African allocation isgeographically complicated, and thereforealso expensive. Yet investors are attracted tothe consistent, risk-adjusted returns thatSouth African hedge funds are generating.Hedge funds make sense for them – thesemanagers have in-depth knowledge of, andunparalleled access to, some of the bestcompanies operating across the burgeoningAfrican continent, and also the flexibility togenerate returns even in economically andpolitically complicated times.In the new environment, domestic investorsare also expected to increase theirallocations to hedge funds. South Africanpension funds have until now had very littleexposure to alternative strategies, butregulated product structures mean they canno longer be ignored for investors seekingsuperior risk-adjusted returns. Manyindividual allocators have also not hadaccess to these types of funds, and thosewho did faced tax uncertainty in the past.Performance over time will always be themain criteria for any investor allocating toany asset class, and here South Africanhedge funds have built a track record ofwhich they can be pleased, with returnsconsistently exceeding their global peers.The HedgeNews Africa South African SingleManager Composite, a median return of allfunds in our database which includes long/short equity, market-neutral andquantitative, fixed income and multistrategy mandates, has returned a netannualised 10.61% (with an annualisedstandard deviation of 1.98%) since ourrecords began in January 2007 to the end ofSeptember 2016. This is in line with thereturns from the Johannesburg All ShareIndex on a total return basis, but withsubstantially less volatility (the index hasadded an annualised 11.03%, with a standarddeviation of 15.21%).The country’s hedge fund industry has grownsteadily since the first fund launched morethan 20 years ago, yet assets are still just afraction of the long-only investmentmanagement industry.While the country can be proud of a skilledgroup of managers whose strategies havestood the test of time, performance andinnovation will remain key areas in the yearsto come.Going forward, it will be interesting to seehow retail (RIF) hedge funds performcompared with QIF hedge funds. As ofmid-2016, around two-thirds of hedge fundshad chosen to be regulated as QIFs,according to data from Novare. This canlargely be attributed to relationships withexisting investors, with domestic fund offunds the largest allocators to the industry.But as a new breed of investor emerges,attracted by regulated products, this couldwell change.levels of leverage compared with their globalpeers. Yet over time RIF funds can beexpected to offer slightly lower returns thanQIF products, as offshore experiencesuggests, yet bring vital diversificationbenefits to broader investment portfolios.Regulatory changes should bring growth forthe industry and, in time, many existing fundsmay not have capacity for new allocations.One important challenge then is to bring newmanagers to market, despite a tougherenvironment for startups. So far, the signsare good that this is happening, as theindustry looks forward to a period ofexpansion on the back of a solid foundation.“In the new environment,domestic investors arealso expected toincrease their allocationsto hedge funds.”Many South African hedge fund mandateswould fit into the retail space, given theirrelatively conservative nature and lowerSTAY CONNECTED / HEDGE15
About Sanne’sHedge businessSANNE established its Hedge businessdivision following the acquisition of IDS FundServices (IDS) on 1 June 2016.Founded in South Africa in 2002, IDS wasestabilished to provide an outsourcedadministration capability in the Hedge Fundindustry, both locally in South Africa but alsointernationally. With the acquisition of IDScame operations, at scale, in Malta and CapeTown, which engaged more than 150 peopleand administers 230 funds totalling in excessof US 7bn.Leading innovative technology platforms,like PAXUS, play an important role in ourhedge offering to clients and we utilise thelatest industry applications to administeralternative assets.As a regulated business in South Africa andMalta, we operate at the highest level ofstandards in terms of our processes andprocedures. We administer a wide range ofstructures that include Cayman, BVI, Malteseand Mauritian funds, as well as onshoreSouth African regulated and unregulatedportfolios. Other areas of focus includemanaged accounts, single and funds offunds, master feeder funds and umbrellafunds. Our dedicated hedge professionalhave extensive expertise in theadministration of most investmentstrategies, including equity L/S, equity M/N,managed futures/CTA, global macro,multi strategy, fixed income and commodity.With the addition of Hedge to our areas ofalternative assets expertise, we provide ourglobal client base with a complete suite ofalternative asset focused administration andreporting services. Should you wish to findout more about our services and operationsin the Americas, EMEA or Asia-Pacific,please speak to us, we would be delightedto hear from you.Graeme RateHead of Hedget: 27 (0) 21 402 1600e: graeme.rate@sannegroup.comTony ChristienDivisional DirectorHedget: 27 (0) 21 402 1600e: tony.christien@sannegroup.comMartin SchnaierManaging DirectorAlternative Assets – EMEAt: 44 (0) 20 3327 9710e: martin.schnaier@sannegroup.comAbout Sanne Group plcThese are the things that make the .com/SanneGroupsannegroup.comInformation on Sanne and its regulators can be accessed via sannegroup.comThe difference
South Africa’s hedge fund industry. Broadly speaking, the Hedge Fund Regulations established certain ‘fit and proper requirements’ for hedge fund managers, introduced the procedures which hedge fund managers are required to follow in order to obtain authorisation to act as such and the created of a Code of Conduct for hedge fund managers.
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Section I Hedge Funds. 9 2. Introduction to Hedge Funds 11 3. Establishing a Hedge Fund Investment Program 37 4. Selecting a Hedge Fund Manager 57 5. Due Diligence for Hedge Fund Managers 69 6. Risk Management Part 1: Hedge Fund Return Distributions 93 7. Risk Management Part II: Additional Hedge Fund Risks
Hedge Fund Spotlight, the monthly newsletter from Preqin providing insights into the hedge fund industry, including information on investors, funds, performance and more. Hedge Fund Spotlight uses information from our online product Hedge Fund Online, which includes Hedge Fund I
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