Before you hedge, make sure you have the edge

Daily Maverick

15-05-2025

Hedge funds, which are becoming increasingly popular in South Africa, have risks and benefits, and you need to make sure your financial adviser is suitably licensed to dispense advice on them.
Question
My son says we should be investing in hedge funds, as it will reduce the amount of risk in our investment portfolio. I'm a bit worried about this, as I have seen stories where people have lost all their money in scams like Bernie Madoff's hedge fund.
Am I being overly cautious?
Answer
Hedge funds are becoming increasingly popular in South Africa, so this question will be relevant to many people.
Hedge funds are different from normal investments, as they use sophisticated financial structures to generate returns or remove risk from a portfolio. They could, for example, buy options to protect the portfolio against a fall in the market or use short selling to profit from a share that is falling. They could also use mismatching in pricing to generate better fixed-interest returns.
The strategies followed by these fund managers are quite technical and require a high level of expertise. The challenge for us is to determine whether these strategies can add value to our investment or whether they will be exposing it to unnecessary risks.
Risk
In South Africa, hedge funds are strictly controlled through an act of Parliament and are overseen by the Financial Sector Conduct Authority. The local controls are a lot stricter than those you would have in other countries.
To ensure that the hedge funds do not unnecessarily expose clients' money to excessive risk, the funds need to meet one of the following criteria:
The leverage limit must be less than 200% of the net asset value. In many other countries, this limit is 800%.
The value at risk (VAR) must be less than 20%. For example, if a hedge fund has a VAR of 15%, it means that there is a 99% chance that you will not lose more than 15% of your investment in a month.
So, when it comes to evaluating the risk of a hedge fund, you should look at these numbers (the leverage limit or the VAR). The lower the VAR, the less risky the fund is.
Benefits of hedge funds
Because hedge funds use different financial instruments, they often behave differently to regular investments. This can offer a level of protection, especially when the markets are very volatile.
When used correctly hedge funds can reduce the risk in a portfolio and improve returns. Last month, we saw the JSE drop by 9% only to finish the month 2% in the positive. By having hedge funds in the mix, you can reduce this type of behaviour in your portfolio.
Hedge funds can also produce an excellent return with a very low risk profile. As these returns are not in the form of interest, they do not trigger normal income tax.
Instead, they will be taxed as capital gains. If you have a portfolio that is attracting a lot of interest income that is taxable, then you could consider adding a hedge fund to the mix to reduce this tax liability without having a material impact on the risk of the investment.
Be careful
Because the structures used in hedge funds require a high level of expertise to manage them, these investments are often quite expensive. Many hedge funds apply a performance fee if the portfolio outperforms a certain threshold.
As a result, when you look at fee structures of investments that use hedge funds, you can see a large amount applied to investment charges. Just remember that the quoted returns are after these investment fees have been deducted.
Not all financial advisers are allowed to advise on hedge funds, since this is quite a sophisticated field. Before you make any hedge fund investments, check that your financial adviser is suitably licensed to provide you with this type of advice. DM
Kenny Meiring is an independent financial adviser. Contact him on 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to [email protected].
This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R35.