Essential investment strategies for uncertain times

03 August 2017

“Middle class South Africans have reacted quickly to the latest political ructions which included the firing of respected finance minister Pravin Gordhan and the resignation of two key Treasury officials. It’s in times like these that the value of offshore diversification is highlighted. And the growth is accelerating with demand for offshore investments at levels last seen during the Global Financial Crisis.”

 

So says a leading Wealth Management Firm in“Middle SA rushing for exit: Demand for offshore investments highest since 2008”, Global Citizen / May 10, 2017 (www.biznews.com).

Have you ever had a strong conviction that the share price of a specific company was headed for a substantial fall, and wished to profit from its decline? What if a massive run-up in a specific sector (like technology in the late 1990s or commodities from 2003 to 2007) leads you to believe that a significant correction is possible and you would like to profit from this view? Or arguably, like the investors alluded to in the before mentioned article, were convinced that the South African political and economic environment will result in an inevitable decline in your portfolio due to a severe bear market. 

Historically, having the strong conviction that a market or a share was due for a long or short term correction had two possible remedies: 
1.  time (remain invested through the cycle) or 
2.  avoidance (find investment opportunities outside of the affected investment environment).

However, neither of these options presents an opportunity to profit from the high conviction view. It seems counter intuitive though, to at best, have no position that can benefit from one’s strongest view. 

Even though the current bout of political uncertainty is causing many SA investors to increase their offshore allocations, most will retain significant allocations to assets in South Africa. For these investments, allocating to a hedge fund of funds is a great way to increase diversification as the short selling the underlying funds do is effectively another source of return for investors. And the proof is in the solid returns the correct hedge fund combinations have achieved.

Short selling is an additional tool that enables investors to potentially benefit from views that markets may fall in value.

Hedge funds employ short selling and became governed by the Collective Investment Schemes Control Act of 2002 on 1 April 2015. This brought hedge funds into the regulatory fold of unit trust funds. It introduces the same stringent oversight to this alternative investment strategy as investors have come to know for traditional unit trust funds. 

The regulation gives the mainstream investor access to an alternative investment that was previously only available to pension funds and select high net worth individuals. It can now serve as an additional source of portfolio return in turbulent times.

Investing abroad is a sure way of avoiding South African specific risks. Portfolio returns are then generated through the opportunities presented in other markets. But by avoiding all South African specific risks, one also avoids all opportunity to profit from these risks, in spite of a strong indication/conviction that the risks will actually play out. 

Hedge funds are hugely diverse in style and aim. But the right combination of South African hedge funds can be a valuable addition to a portfolio already investing in opportunities abroad by introducing an alternative source of South African returns in line with the bearish view. 

But how does short selling work? 

Short selling is also known as “being short.” To be short a security or asset implies that one is bearish on its prospects and expects the price to decline.

In simple terms, you execute a short sale by borrowing the asset that you wish to short sell, and selling it at the current market price. If and when the price of the asset declines, you buy it back and return it to the lender. The difference between the price at which you sold the asset and the price at which you bought it back represents your gross profit or loss. 

As you can see, short selling follows the conventional investing principle of “buying low” and “selling high” but with one critical difference – the sequence of the buy and sell transactions. While the buy transaction precedes the sell transaction in conventional “long only” investing where a bullish view is expressed, short selling reverses the conventional investing principle of “buying low” initially and “selling high” later, by seeking to sell high first and buy low later to express the bearish view. (www.investopedia.com)

Especially in turbulent times like this, investment portfolios’ longevity relies on the consideration of all opportunities. Diversifying into as many sources of return to express a view is paramount for most investor profiles.

The regulation gives the mainstream investor access to an alternative investment that was previously only available to pension funds and select high net worth individuals. It can now serve as an additional source of portfolio return in turbulent times.

Constructing our portfolio of hedge funds: Ashburton Select Retail Investor Hedge Fund of Funds

The aim of the Ashburton Select Retail Investor Hedge Fund of Funds is to provide an investor with a wider set of investment possibilities through the use of hedge funds that will have a diversifying effect relative to traditional asset classes to enhance longer term returns. The aim is to provide a multi hedge fund advisor solution that will diversify the investor’s risk and return exposure to include shorting and well managed leverage. The fund is for investors seeking 
1. for broader diversification of investment opportunities, while having a bearish view on SA Equities 
2. to add more growth potential to their portfolios, but are wary of extreme market swings

The asset allocation solution 

Hedge funds are fairly new to the retail market and the majority of investors are still mostly allocating to the traditional asset classes locally like equities, bonds and cash. However the potency lies not necessarily allocating to hedge funds on a standalone basis but by combining it with other traditional asset classes. At Ashburton we have designed multi asset, multi instruments segregated portfolios that include direct shares, bonds, listed property shares, ETFs, offshore funds and hedge funds. Through the construction of an outcomes based portfolio we found that the inclusion of hedge funds had a very constructive effect on the risk and return profile of the overall portfolio. 

To illustrate we’ve plotted the Ashburton Growth Hedge Portfolio (a selection of hedge funds) on a risk return scatter plot relative to the funds in the ASISA General Equity Category and Multi Asset High Equity Category over 5 years. The chart illustrates that the hedge portfolio generated similar returns to that of the average multi asset high equity category and the general equity category but at much lower risk (volatility). 

One can therefore conclude that short selling within the underlying hedge funds is effectively another source of return for investors and that allocating to a hedge fund of funds is a great way to diversify and reduce the risk of the overall portfolio without sacrificing returns. 

5 Year reward: Ashburton growth hedge portfolio vs ASISA SA Multi Asset High Equity and general categories

Source: Morningstar, Realfin Fund Services