Over the years as international investors have searched for yield and found themselves looking towards Africa, many have invested with a long-term mindset focused on private and public equity strategies. Both strategies offer promising returns over the longer term, but the higher returns do not come without lack of liquidity and significant volatility.
One source of remarkably consistent alpha and attractive risk-adjusted returns has been the South African hedge fund industry. While it is true that it is difficult, if not impossible to hedge in most markets throughout Africa, this isn’t the case in South Africa. With a market capitalization of $354bn, the Johannesburg Stock Exchange (JSE) has an average daily trading volume of $1bn, according to the ICBC Standard Bank Research.
The cost to borrow in many emerging markets can be quite expensive and in most cases borrow is non-existent. This is not the case in South Africa. The cost to borrow on the JSE is approximately 50 basis point per annum and the exchange has a very liquid options market. The country’s financial infrastructure and regulatory framework ranks amongst the top globally when it comes to best practice. In fact, South Africa’s financial market development overall ranks just outside the top 10 according to the 2015-16 World Economic Forum report.
South African hedge fund managers have done an exceptional job in outperforming their global peers. Since January 2007, the HedgeNews Africa South African Single Manager Composite Index annualized 10.7% in Rand terms (to adjust to USD deduct 5-6% for the cost of hedging). Over the same period, the HFRI Fund Weighted Composite Index annualized 3.1% in USD terms. Both composites are broad in nature and include all strategies. Taking a slightly better proxy over that time period, given that 60% of South African hedge funds are equity long short strategies, the HFRI Equity Hedge Index has annualized 2.5%. Over a 3-year and 5-year timeframe, the comparable statistics look similar.
While the South African peer group is made up of Rand denominated funds, a smaller sub-set of South African hedge fund managers have attracted international capital over the years by offering Dollar denominated investment vehicles. Given how liquid the currency market is in South Africa it is very inexpensive to hedge. Managers with offshore offerings have still managed to generate double digit net annualized returns in their Dollar funds, something most hedge funds managers abroad struggle to achieve over an extended period of time. For example, Laurium’s offshore USD fund, the Chobe Long Short Fund, has had a net annualized return of 11.8% since inception in December 2008.
So how have South African hedge funds managed to outperform?
Size does matter
The global hedge fund industry reached $3.2trn at the end of 2015. According to Preqin, 60% of hedge fund assets are managed in North America, with 19% and 17% coming from Europe and Asia Pacific, respectively. Only 4% ($127bn) comes from the rest of the world. While the rest of the world’s hedge fund assets are no small sum, the South African hedge fund industry’s total assets are pale in comparison (see Chart 1).
In Novare’s 2015 Hedge Fund Survey, it was reported that the South African hedge fund industry totaled R62.0bn ($4.8bn) in assets under management [Using the 2015 average ZAR/USD exchange rate]. This is a small number when put into the global context but being small can have its advantages. The South African traditional long-only unit trust market is estimated to be around R2trn ($155bn). There is no question that being good stock picker is what makes money, but to generate alpha and outperform longer term investors need to have the ability to be nimble.
Not just a South African play
Just like the rest of the continent, South Africa has had its fair share of bad press recently. Political and economic headwinds have plagued the rest of the world’s appetite to invest in the country. There is no denying that the South African economy does not have the same growth outlook as rest of the African continent, this fact alone should not discourage investors from considering to invest in the South African equity market. One of the interesting points about the South African equity market is that it is quite diversified with a meaningful portion of the index being internationally exposed. RMB Morgan Stanley recently put out a research report outlining the JSE geographical composition (See Charts 2 & 3).
Over the past 10 years the offshore exposure of the JSE Top 40 Index, which is an index comprised of the top 40 stocks by market-capitalization listed on the exchange, has grown by 30% and now stands at 73%. Global companies such as SAB Miller, BHP Billiton, Anglo American, Richemont and even Naspers all originated out of South Africa, but today have more of their profits derived offshore.
The diversification of the JSE is perfect for hedge fund investing. Not only can managers go long stocks which derive meaningful earnings from offshore but they are able to short companies, which are geared to the South African economy. Having this optionality allows hedge fund managers to be nimble and are able to capitalize on opportunities others cannot. Hedge fund managers also have the ability to better protect positioning when during risk-off environments.
Established Track Records
While South Africa is yet to be on the radar for many global hedge investors, this is not a new industry. Many managers in South Africa have a seasoned track record. According to Novare’s 2015 Survey, 39.8% of hedge fund assets in South Africa were managed by portfolio managers with over 10 years’ experience. These managers have proven to manage money through the cycle and build sustainable businesses.
As the hunt for yield continues and a third of global government debt is yielding negative, investors must not dismiss Africa for either illiquid or a pure beta play. There are opportunities to make attractive risk-adjusted returns even when the macro outlook does not look rosy. You just have to look a little further south.
Jaclyn Petrone is the Director of International Business Development at Laurium Capital.
As originally appears https://www.africaglobalfunds.com/analysis/analysis-and-strategy/south-african-hedge-funds