The long and short of hedge funds - B2B Central (2024)

By Jean Pierre Verster – Portfolio Manager, Fairtree Capital.

The Steinhoff-saga in December 2017 and reports by activist short-sellers recently put hedge funds in the spotlight.

How does short-selling work?

Short-selling is where a speculator attempts to make money from a falling share price, rather than the traditional way of making money from a rising share price. The speculator needs to borrow the shares from a current shareholder, and in return pays a borrowing fee. The speculator then sells the shares in the market, but has the obligation to buy them back at some point and return the borrowed shares to the current shareholder. The borrowing fee earned is an attractive extra source of revenue for certain shareholders such as exchange-traded funds, pension funds and equities trading divisions of banks. Stockbrokers or securities lending specialists facilitate these scrip borrowing/lending transactions.

Isn’t short-selling bad and shouldn’t it be banned?

Short-selling is a legitimate activity in a free market where supply and demand determines price. It maintains equilibrium in markets, ensuring that buyers cannot overwhelm sellers and force the share price of companies up to artificial levels, sometimes called ‘cornering the market’. Short-sellers assist in the efficient allocation of capital towards companies which create value, and away from companies which destroy value. Successful short-sellers have an incentive to seek out over-valued shares, profiting from the correction of that overvaluation to more appropriate prices, enhancing the confidence of market participants that price is an indication of value.

Short-selling becomes problematic where a short-seller makes false and/or misleading public statements about a company to scare buyers and drive down a share price. Short-sellers often operate anonymously, given the personal risks that they might face if a company should decide to employ bullying and/or smear tactics to keep critics quiet. Most short-sellers do their work quietly, not wanting to attract too much attention. Only a handful of short-sellers are activists, preferring a public and aggressive approach, which is problematic if they do turn out to be wrong.

Most of the short-selling activity on the JSE is done by regulated hedge funds where a company whose shares are being shorted is but one of many companies constituting the short portfolio (or short book) of a hedge fund. This is done not because the hedge fund manager necessarily believes that all the companies whose shares are being shorted will drop significantly in price, but rather as a risk management tool to offset the risks taken in the portfolio of shares held in the traditional way (the long book).

How can I benefit from short-selling?

The only regulated investment vehicles which are allowed to employ short-selling are hedge funds, which have been strictly regulated in terms of the Collective Investment Schemes Control Act since 1 April 2015. While hedge fund managers themselves have been regulated since 2008 in terms of the Fit and Proper requirements contained in the Financial Advisory and Intermediary Services (FAIS) Act of 2002, the fact that hedge funds (the investment vehicles) have only been regulated for about 3 years means that they are mostly still an unknown and under-researched investment option for advisors and retail clients.

How do I choose which hedge fund to invest in?

Specific emphasis should be placed on the risk management framework of the hedge fund. Because hedge fund managers utilise leverage and short securities, they need to take particular care in terms of the exposures they take. A lack of proper risk management can lead to significant losses, so the investor should gain comfort in the risk management processes that the hedge fund manager is subjected to. One way to assess if risk is being managed prudently is to check what the magnitude of the largest historical monthly loss was for the hedge fund, especially for tumultuous months such as December 2017. Mandate limits in terms of maximum gross exposure and single security concentration are also useful measures to assess the risk management framework.

Is the fee structure fair? Most hedge funds charge a reasonable base fee of around 1% and a performance fee with a hurdle, according to the high watermark principle. This means that the hedge fund manager will only be able to charge an above-average fee if an above-average outcome is delivered. While this fee structure seems fair, many large investors such as hedge fund-of-funds and pension funds are able to negotiate even better terms in return for larger investment sums.

Conclusion

Hedge fund managers need to up their game and exceed on realistic investor performance expectations, at a reasonable fee, before the industry will see the growth eagerly anticipated by participants. It does seem, however, that this ideal is within reach, even if it means that a bear market is required as a catalyst to get us there.