Understanding retail hedge funds: a guide to this evolving asset class

Retail hedge funds are a relatively new addition to the investment options available to retail investors in South Africa. Their “older siblings”, qualified investor hedge funds, have been around for more than 26 years and have served investors well. You may want to carefully consider this new opportunity and familiarise yourself with the workings of hedge funds.

Hedge funds differ from traditional unit trust funds in that they employ a diverse range of investment strategies to generate returns. These strategies enable them to deliver strong returns even when financial markets are struggling. Additionally, these strategies contribute to the lower risk associated with hedge funds.

Two of the strategies used by hedge funds include short selling and pair trades. Short selling allows a hedge fund manager to benefit from a drop in share prices, a tactic that traditional fund managers cannot use.

Pair trades allow a hedge fund manager to benefit from the share price movement of one company relative to another. A pair trade is established by owning company A and shorting company B. In a falling market, the hedge fund manager can generate a positive return if company A falls less than company B. In a rising market, a positive return is possible if company A rises more than company B.  The overall direction of the market does not determine the profitability of pair trades. The returns produced by pair trades therefore have a low correlation with stock market returns. 

The performance of the Peregrine Pure Hedge Qualified Investor Fund and Peregrine High Growth Qualified Investor Fund, over the last 10 years, provide an example of the excellent returns that hedge funds have been able to deliver. See data in tables below. While these two funds are qualified investor hedge funds, their retail equivalents are managed on the same basis. The long-term track record of the qualified investor funds are therefore a good indication of how the retail investor funds would have performed. The data shows that these funds delivered stellar outperformance, with significantly lower downside volatility, as measured by maximum drawdown.

Table 1: Performance of the Peregrine High Growth, Qualified Investor, hedge fund

Table 2: Performance of the Peregrine Pure Hedge, Qualified Investor, hedge fund

The lower risk, and specifically the lower downside volatility of hedge funds, make them very attractive for use in products where regular withdrawals are made. One such product is a living annuity.

Retail hedge funds operate within a highly regulated framework overseen by the Financial Sector Conduct Authority (FSCA). This regulatory environment ensures that retail hedge funds adhere to strict investment and risk guidelines, safeguarding investor capital. The legislative framework allowing retail investors to access retail hedge funds was established in 2015.

In South Africa, various hedge fund strategies are available to the retail market. South African hedge funds attracted record net inflows of R6.24 billion in 2023, growing the assets under management to R137.9 billion.

Regulation 28 of the Pension Funds Act allows investors to allocate up to 10% of their retirement portfolios to registered hedge funds. This allocation is subject to a limit of 2.5% per individual hedge fund or 5% per fund of hedge funds.

Hedge fund managers typically charge higher fees than traditional asset managers. However, these fees are only earned when the manager outperforms the fund’s benchmark. Ultimately, what matters to investors is the net-of-fees return and how it compares to the returns of other investments. On a net-of-fees basis, hedge funds compare favourably with traditional asset manager returns.