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    Hedge funds - The Alternative Asset Class

    In the minds of most investors the word hedge fund doesn’t inspire confidence. Hedge funds unfortunately have a bad reputation, which is mostly due to the sensational headlines that get published about some of the offshore funds that went bust. The news stream is one way as legislation prohibits hedge funds from marketing themselves in South Africa.

    South Africa’s first hedge fund was started in 1998 due to demand from institutional pension funds that wanted an asset class that would be able to provide a stable cash plus return that wasn’t highly correlated with the markets. This is still the overall objective of most of the SA based hedge funds.

    Hedge funds have a few additional tools available that long only and unit trust managers don’t have. Hedge fund managers are able to short instruments (sell assets they’ve borrowed) and use leverage (invest more than R100 for each R100 contributed). If a manager believes that the share will increase in value he will buy it, and sell it when he believes that the share has reached its fair value. If the manager believes that a share is overpriced he will short it, i.e. he will borrow the share and then sell it. After the share has gone down in value he will buy it back at the lower price and return it to the institution that he borrowed it from at a profit. If the share price goes up he’ll make a loss.

    The graph below shows how the same fund manager was able to unlock additional returns by correctly deploying these tools.

    The blue line shows the cumulative return of a unit trust and the red line the cumulative return of a hedge fund managed by the same manager. The funds have the same investment strategy and process, with the major difference being that the manager is able to make use of shorting and leveraging in the hedge fund.

    As with unit trusts you get different types of hedge funds. The three main strategies employed are Long Short, Market Neutral, and Fixed Income. Long Short funds try to profit by buying companies that they like and shorting those that they don’t. Market Neutral funds aim to remove the market risk from funds, by pairing long and short positions. Fixed Income funds make use of fixed income instrument like bonds, interest rate swaps, interest rate futures, etc.

    The table below shows how hedge fund returns compare to other indices. The returns of this hedge fund index are compiled by a local asset manager of hedge funds that partake in their monthly survey. The returns are cumulative until the end of January 2012.

    The hedge fund strategies might not outperform the ALSI over all periods, but are more consistent in their returns. From the graph below you can see that over a 5 year period hedge funds were able to provide comparable returns to the ALSI at a much lower risk levels.

    There are some drawbacks to hedge funds. Hedge funds are not FSB approved, but hedge fund managers must have an FSB Category IIB license to manage a hedge fund. The fund managers try to overcome this hurdle by providing transparency in their dealings, independent custodians, administrators, and compliance. The entry point for hedge funds is higher than unit trusts as the minimum investment is generally R1m. Most hedge funds trade on a monthly basis and might have notice periods for disinvestments.

    Hedge funds aren’t suitable for every investor, but can provide an excellent building block in your asset allocation. Hedge funds are not highly correlated with other assets. They provide more stable returns than most asset classes and are able to provide some capital protection in bear markets.

    Kind regards,

    Gerbrandt Kruger
    021 9144 966

    Permalink2012-02-28, 14:52:00, by Mike Email , Leave a comment

    Budget Speech 2012

    Being a country’s Finance Minster is never an easy task. It is one of those jobs where you’re only able to please some of the people some of the time. With many world economies currently struggling with sluggish growth and high debt levels, this job is understandably not on the top of everyone’s list of most desirable job list.

    South Africa is fortunate in that it doesn’t have high debt levels and growth is at least expected to be positive, but the levels of unemployment require that we grow at rates not often seen in South Africa. Public debt is expected to rise to 38% of GDP in 2014/2015 and then fall from there, this is much more sustainable than the figures closer to (and in some cases above) triple figures in Europe. Economic growth is expected to come in at 2.7% for 2012 which compares unfavourably to Sub Sahara Africa (5.5%) and developing Asia (7.3%), but is better than Developed economies at 1.2%. With inflation to the end of January coming in at 6.3%, South Africans should see nominal economic growth of around 9% in 2012.

    The budget contained the usual target areas, but it was noticeable that there was a slight shift in focus from spending on consumption to spending on development of infrastructure. Pravin Gordhan wants government departments to rein back on salaries and focus instead on improving efficiency of delivery – it is estimated that only 68% of planned expenditure was spent in the current financial year! Social spending currently comprises 58% of government expenditure – up from 49% a decade ago – and the Minster admitted that the best way to reduce this dependence is through job creation and economic growth, not just increasing the subsidies.

    In tough economic times there is extra focus on revenue collection and in this instance SARS (which Mr Gordhan used to be head of) has assisted in bringing in 5 million tax returns in the most recent tax season – this is some 23% more than the prior year. There was also an extra R 1 billion in tax revenue from the recent Voluntary Disclosure Programme. By widening the tax net the government is hopefully able to keep tax increases to a minimum by spreading the burden across a bigger income pool.

    Personal Income Tax

    There was the usual bracket creep for income tax rates. The chart below shows the monthly tax payable and average tax rate for the new (2013) tax year for tax payers under 65. It also shows the tax saving made at various income levels – you will notice that there are bigger percentage savings for the lower income levels.

    The change in medical expense treatment has been discussed before by Treasury. Previously, qualifying medical expenditure came off your income (and in essence was credited at your marginal rate) this has been now been changed to a tax credit system. This change has the effect of giving a bigger tax break to those with marginal tax rates below 30% and reduces the deduction from those with higher marginal rates. R230 per month for the first two beneficiaries and R154 per month for each beneficiary thereafter from qualifying medical spend (medical aid contributions) will be taken off your tax bill from 1 March 2012.

    Two of the bigger announcements that will particularly affect high net worth individuals with large discretionary savings are the increase in the tax on dividends to 15% (remember this tax is moving from the company’s responsibility to the tax payer’s responsibility from 1 April 2012). Secondly the inclusion rate on capital gains will be increased from 25% to 33.3% for individuals and special trusts and 50% to 66.6% for companies and other trusts. This will make the effective tax rate on capital gains just over 13% for individuals in the top income bracket (from 10%) and nearly 27% for family (and other) trusts (from the previous 20%). To help alleviate some of the pain the annual CGT threshold has been increased to R 30 000 (from R 20 000) the exclusion on death to R 300 000 (R 200 000) and on primary residences to R 2m (R 1.5m).

    As savers in recognised retirement products (pension, provident, retirement funds) get relief from dividend tax and capital gains, the Treasury is, in essence, trying to make these regulated savings mechanisms more attractive. Naturally you do pay income tax rates when they mature, so each individual would need to look at their own specific situation. There is also consideration being given to savings products that would provide tax exempt growth for the short to medium term – with limits being imposed to avoid high net worth investors getting any undue benefit.

    The annual budget is an opportune time for investors to relook at their investments to determine whether they have taken advantage of the breaks offered by government and optimised their portfolio based on the current and proposed legislation.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2012-02-23, 17:48:03, by Mike Email , Leave a comment

    Retirement Funds – Thinking Outside the Box

    I want to start this newsletter with a riddle:
    “Mr Jones drives in his two seated sports car on a stormy, rainy day. He notices three people standing beside the road, Jerry, his very good friend for years, an old lady that needs to go to the hospital, and a beautiful blonde woman. What should he do?”
    (The answer is shown at the end of the newsletter)

    It is very interesting to talk to private clients and their understanding regarding their retirement fund. Most of the time members of retirement funds don’t understand their benefits and how to maximize them.

    So where is the problem?

    There are so many stakeholders involved in a retirement fund but ultimately all the stakeholders should be there for the benefit of the members of fund. However, very often that is not the case.

    The old retirement funds (i.e. Defined Benefit funds) were quite easy to understand from a member’s point of view. The only thing a member had to do was to work at the same company for 30 to 40 years to secure pension of about 70% of his/her salary at retirement.

    The new generation retirement funds (i.e. Defined Contribution funds) are also easy to understand but complicated to manage. It is easy to understand because each member is building his/her own portfolio of assets. It is difficult to manage because members need to make sure that they:
    - Contribute enough for retirement,
    - Invest in the correct portfolio to ensure retirement, and
    - Work long enough to ensure the value of the fund is large enough to finance an ongoing pension for the
    next say 30 years after retirement.

    My experience shows that members of these new generation retirement funds don’t understand their benefits and risks because it hasn’t been adequately explained by the stakeholders. The stakeholders are the investment consultant to the trustees, the asset manager of the retirement fund, the broker consultant to the fund and the broker consultant to the member.

    If the stakeholders can come together and jointly provide a holistic service to the trustees and ultimately the members, then each member of a retirement fund should be able to answer the following basic questions:
    - How much do I need to contribute to ensure a comfortable retirement?
    - What type of portfolio do I need to invest in to ensure a comfortable retirement?
    - How much capital do I need at retirement to be able to retire comfortably?
    - How much life cover do I have?
    - How much disability cover do I have?

    If one can’t answer the questions above then one should probably ask the question whether the stakeholders are really doing their job.

    To be able to address the needs of the members of retirement funds the stakeholders will need to think outside the box.

    Kind regards,

    Vincent Heys

    PS: The answer to the “outside the box” riddle is:
    “Mr Jones gives his car to his friend Jerry to take the old lady to the hospital so that he can stay behind with the beautiful blonde woman.”

    Permalink2012-02-22, 09:34:24, by Mike Email , Leave a comment

    2012 Possible Returns

    While local shares produced a total return of only 2.6% in 2011, January saw enthusiasm for so called risk assets come back into favour, as the JSE All Share index gained 5.7%, taking the index to a new all time high by the end of January to a level of 33 793.

    Many investors still get confused with the nominal value of the index, equating it to the value of shares in general. However this nominal index number is merely an average price for all the shares comprising that index. The price of a share is a multiple of its earnings generated by a factor, known as the PE ratio, or price to earnings ratio. When looking at the market as a whole, it is important to focus not on the nominal index number, but rather on what level of earnings this represents. Having an understanding of the starting point is important in trying to assess the future return.

    If we try and anticipate the returns from the market going forward one year and two years, we really need to know only 2 inputs – simple, yes, but not easy. The first is the growth in current earnings, i.e. what the level of total company earnings will be in the future and secondly what the multiple that investors will be prepared to pay for these earnings is.

    The index is then merely the product of average company earnings and the PE ratio. Forecasting company earnings is possible, albeit difficult, but even more uncertain is trying to predict what investors will be prepared to pay for those earnings (i.e. the PE ratio). What we do know about the PE ratio is that it is mean reverting and so both high and low PE’s move back to the average over varying periods of time. Over the last 50 years the PE on the JSE has had an average of 11.9 with a one standard deviation range of 8.2 to 15.6.

    Looking at the specifics for 2011 helps illustrate the mechanics. At the start of 2011, investors were prepared to pay 17.3 times earnings (i.e. the market was expensive relative to its long run 11.9 times). During the year earnings grew by 34.6%, but by the end of 2011 investors were only prepared to pay 12.7 times earnings. The result in the contraction in rating was an index that declined by 0.4%, despite the exceptional earnings growth.

    At the end of January 2012, earnings had climbed slightly to 2 518, while the PE rating had moved to 13.4 times. Looking ahead we can make the following forecast scenarios.

    Should company earnings grow by an average of 12% in the year and the market rating remains at the same level as it is currently, investors can expect a total return of around 15%. Should earnings grow by 15% and investors become more enthusiastic again, driving the PE to 16, then a 40% total return is not impossible. On the downside should a reasonable earnings increase be offset by a de-rating of the PE to 11, then investors will sustain a loss of 8%.

    The variance in one year forecast reflects the difficulty of shorter term forecasts. Because of the mean reversion in valuations, we prefer to adopt a longer term forecast such as 5 years, which has a higher predictable outcome.

    Kind regards,

    Ian de Lange
    021 9144 966

    Permalink2012-02-14, 17:27:18, by Mike Email , Leave a comment

    Treasure Hunting

    There was a point in my life when I wanted to be a pirate. I wanted the sword, the parrot, and the treasure at the end of the treacherous journey. The starting point of any heroic quest to a lost buried treasure starts with a treasure map. My pirate career never really took off, but I never stopped looking for a map that would lead me to the treasure.

    A budget can be seen as a modern day version of a treasure map. Both are hard to follow, but if followed can lead you to a treasure. Starting a budget for you or your household can be seen as finding a treasure map.

    The first step to draw up a budget is to know your income and how it is spent. One way to see how you are spending your money is to go through your bank statements and savings account. From there you will be able to find out what you spend your money on and what your monthly total is.

    The second step is to make a list of all the expenses that you would expect to have during a month. You need to split the list into fixed and variable expenses. Fixed expenses occur monthly and are relatively stable and include items such as mortgage/rent, car payments, levies, and medical aid. Variable expenses by their nature are more volatile and are where most of the lost treasure is hiding. Some examples of variable expenses include groceries, petrol, clothing, cellphone bills, eating out and holidays.

    From the list of your expenses you will be able to see how much you spend in a month versus your monthly income. If your income is more than what you are spending then you’re already on the right path to financial freedom (the treasure). You should also make sure that you include a savings portion in your budget to save for a rainy day.

    If your expenses are more than your income you have two options. Either you will need to increase your income or cut back on your spending. In the short term it is usually easier cut back on spending than it is to increase your income.

    Expenses can also be grouped into necessities, comforts, and luxuries. The necessities are goods/services you can’t live without – the things that you need to survive. Comforts make living easier such as smartphones and buying food from Woollies. We all know what luxuries are: designer clothing, the newest gadgets, expensive holidays, etc. Your money should first be allocated to necessities, then comforts, and any leftover can be spent on luxuries.

    With a completed map in hand you can start the journey to the ‘X on the map’ – financial freedom. However, you also need a compass to keep you from straying off course. In the technological era there’s no need for outdated compasses. Applications (apps) that you can use to easily track your daily spending can be downloaded onto most smartphones. These will help ensure you don’t get lost in the ‘jungle of overspending’ or the ‘swamps of impulse buys’. Naturally the pen and paper system also works, but will take a bit more effort.

    You now have the completed map, the way forward, and the means to keep you on the path to the coveted treasure. The road might be treacherous, but the reward in the end (financial freedom) is worth the adventure.

    Kind regards,

    Gerbrandt Kruger
    021 9144 966

    Permalink2012-02-08, 09:50:46, by Mike Email , Leave a comment

    Core and Satellite Investing

    Most investors know not to put all their eggs into one basket, but how about one medium-sized basket and a number of smaller, flashier baskets? The Core and Satellite approach is a clever combination of the two primary approaches to investment management: active and passive investing.

    Passive management is a strategy followed by investors who believe that in principle markets are efficient and that it is not possible to outperform the market consistently after allowing for the risks taken on. In practice this approach involves investing in an appropriate index fund or a suitable, low-risk unit trust that closely follows its benchmark. These investors will never outperform the market or the stated benchmark, but management fees are very low and the portfolio will at least keep up with market returns.

    In contrast, active investors believe that market inefficiencies can be exploited to achieve returns in excess of their benchmark or market indices. Active managers invest into assets that are undervalued in an attempt to make a profit as the market eventually corrects for the mispricing. Investors are able to outperform market indices or other benchmarks over time, but only if competent managers making the right investment decisions are selected. The negative to active management is the higher cost when compared to the passive management.

    The Core and Satellite then is a blending of these two methods in order to achieve the best of both worlds – the possibility of outperformance at a lower overall cost.

    Using this methodology, the Core portfolio forms the foundation of the total fund, and should be positioned to achieve stable returns at relatively low risk. It will usually comprise 40% - 60% of the total portfolio and in order for the overall strategy to be successful, the Core portfolio should have as low an overall cost as possible. Investment into a selection of index tracker funds or enhanced tracker funds should typically achieve this objective.

    The Satellite portfolios are smaller amounts allocated to specific active investments, added purposely to enable the total portfolio to outperform its benchmark. These portfolios should be managed by skilled active managers who are able to outperform their benchmarks by investing very differently to the benchmark. Managers with different styles, e.g. value or growth, can be selected, as well as different themes such as commodities, emerging markets or small caps. It is important that these managers are aggressive enough in their approach to justify their higher management fees.

    The resulting combination of the Core and Satellite portfolios offers the following advantages:

    • Increased stability of returns:

    The portfolio should deliver more stable returns more closely matching those of the benchmark, with the
    added possibility of some outperformance if the active managers perform well.

    • Reduced Management Cost:

    The Core portfolio, with its lower management costs by design, will bring down the overall costs of the
    portfolio. As the Core portfolio is often based on indexes that do no change often, there should be lower
    transaction and rebalancing costs.

    Overall, the Core and Satellite approach offers a flexible, cost-effective way to manage an investment portfolio.

    Source: www.hottingerzurich.com

    All the best,

    Cor van Deventer
    021 9144 966

    Permalink2012-02-01, 17:23:06, by Mike Email , Leave a comment