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January

Let me begin by wishing you all a successful and happy 2005, I hope you all had a good rest during December.

I have just returned from an amazing holiday to Zimbabwe, which is a wonderful country. Seeing the decline in Zimbabwe however made me conscious of the ramifications of having all your eggs in one basket. The Zimbabwe dollar used to be stronger than the ZAR. Now at over Z$1000: ZAR1, you can imagine the havoc this has created for Zimbabweans living on a domestic pension.

In the last edition of the newsletter I covered some economic issues and started a series on hedge funds, the aim of which was to provide you with information about this relatively new asset class. I have attached that newsletter to this email, in case any of you would like to revisit some of the concepts raised.

In summary the following points were made:

1. Hedge funds generally protect capital when markets are falling
2. Hedge funds outperformed equities over the past 5 years on a risk adjusted basis (i.e. investors in hedge funds took on lower risk and got better returns than traditional equity funds)
3. Hedge funds are not a fad. They are becoming an important part of the asset allocation decision of individual and institutional investors.

Economic news

Current exchange rates
ZAR/USD	5.95
USD/Euro	1.30
USD/GBP	1.87

On the economic front, the dollar behaved according to predictions, and with it the ZAR moved to its strongest level in 5 years. The US Fed has since pushed up their interest rates by 0.25% and this has brought some weakness to the ZAR where it is currently hovering at around the R6.00 level. Gold has been relatively stable at about USD425 per ounce.

Oil seems to be caught in the USD45.00 to USD50.00 per barrel range and prices continue to be driven by demand from emerging markets such as China where demand for oil grew 35% in December 2004, and India. It seems likely oil prices will continue to remain in this range for the short term, increasing concerns about global inflation. Higher oil prices have hit earnings offshore and this, together with geopolitical uncertainty (Bush’s re-election seems to be a major global destabilizer!), has affected global stock prices already with some analysts citing this as one of the main reasons for the S&P being down for the third straight week this year.

Many of you have asked me for my opinion on where the ZAR will go this year. Once again, I have to reiterate that it is difficult to predict but here are my thoughts anyway:

ZAR/USD – this rate will be driven by how the dollar performs against other currencies and it will also depend on US interest rates. The US current account deficit (at about 6% of GDP) continues to be of major concern. This is putting the US dollar under pressure. In an attempt to reverse this, the Federal Reserve appears to be targeting interest rates of about 3.5%-4% by the end of 2006, where the effect on the US economy with rates in this range are considered to be “neutral” . Currently the rate is at 2.25%. So there should be a gentle climb in US rates during this year and into 2006. The differential between our rates and theirs will narrow and this should bring some further weakness to the ZAR. We saw the ZAR weaken by approximately 10% when US rates were raised by 0.25% in December, so my suggestion is to watch those US rates carefully.

There have been some comments in the press that due to problems with exports and manufacturing there is pressure to lower interest rates in SA. If rates are reduced, the rand will weaken thus putting upward pressure on inflation. Lowering rates will also spur continued consumer spending (i.e. borrowing) which will have an inflationary effect too. Given that Tito’s main issue is inflation targeting, I can’t see him lowering rates and consequently see a low probability of rates being lowered this year.

Because of the upward trend of interest rates in the US we should see a gradual weakening of the ZAR against the USD for this year. However, if SA rates follow the offshore trends and climb, then there will be a balancing effect between the rates of the US and SA. The ZAR/USD rate will then be determined by the relative strength or weakness of the USD. As mentioned in my letter last year, the prediction is for the dollar to continue to weaken and that means a stronger ZAR.

In summary, we are likely to see the ZAR weaken as rates in the US rise. This will be offset to some degree by a weaker USD. My view is that the change in interest rates will have a greater effect than the weakening trend of the USD so there is likely to be a gradual weakening of the ZAR during 2005 and 2006.

Hedge Funds

I want to now look at the history behind hedge funds, what a hedge fund is and how hedge fund managers differ from traditional investment managers.

Brief History

In 1949, Alfred Winslow Jones (an Australian) utilized short selling (i.e. selling shares you don’t yet own) and leverage (i.e. gaining a greater level of market exposure to initial capital invested) to protect his portfolio of shares in a falling market, to preserve his capital and to achieve superior returns over the long term. Fortune magazine ran an article in 1966 on Jones entitled, “The Jones that no one could keep up with” because he had the best performing equity funds during the 1950’s and 60’s.

Since then, the hedge fund industry has grown from being predominantly US based to a global one. The growth in the industry was accelerated through the 1990’s because of the increase in new financial vehicles and a change in technology which facilitated the development of sophisticated investment strategies without the need for backing by the large investment houses .

There are now about 8000 hedge funds globally with about USD1 trillion of assets under management. It is now the fastest growing asset class with pension funds globally allocating 5%-10% of their assets to hedge funds.

What are hedge funds?

While there is no standard international definition of hedge funds, these investment structures typically display the following common characteristics:

1. The funds utilize short selling to reduce risk and preserve capital
2. The funds use some form of leverage, measured by the gross exposure of the underlying assets exceeding the amount of capital in the fund
3. Derivatives are used
4. Managers charge a fee based on their out performance usually compared to a benchmark such as inflation or interest rates
5. Managers usually manage their “own” funds alongside investors

There are many different styles or strategies used by hedge fund managers. Generally, when a fund manager “hedges”, he is trying to lock in his profit on buying and selling a share (or other financial instruments), in advance. Consequently, using various forms of hedging, the hedge fund manager reduces the risk or exposure to the market because he already knows what he has sold them for. The degree to which a hedge fund is “hedged” varies markedly across managers.

Comparing hedge funds to traditional funds

Hedge fund managers differ from traditional active managers managing traditional “long only” funds in two significant ways:

1. Risk
   Most hedge fund managers define risk in terms of potential loss of invested capital (total risk) whereas traditional asset managers define risk as the deviation (tracking error) from a stated benchmark. The risk associated with a hedge fund is therefore highly dependent on the skills of the individual manager.
2. Return
   Hedge fund managers aim to deliver a total return unrelated to a benchmark or index. Their performance is therefore independent of the direction of the general direction of the markets. A traditional manager largely aims to deliver relative returns (returns above a related benchmark). This relative return may be negative if the benchmark is negative. The generation of returns by hedge funds is reliant once again on the skill of the manager, whereas traditional strategies primarily reflect the return of the underlying asset class.

Other differences between hedge fund investing and traditional investing are as follows:

In summary therefore, hedge funds are generally defined as

Characteristic	Traditional Investing	Hedge Fund Investing
Investment strategies	Limited to long positions only. Do not use leverage.	Flexible investment strategies. Can use leverage and can take long and short positions.
Market correlation	High correlation to the market	Generally low correlation to market
Performance	Dependent on market direction	Independent of market direction
Fees	Tied to assets under management	Tied to performance
Managers investment	Managers generally don’t co-invest alongside investors	Managers generally co-invest alongside investors

funds which use short selling, derivatives and leverage to generate their returns. Hedge fund managers don’t rely on the direction of the market to make their gains. Individual hedge fund manager skill is key to performance. Consequently, hedge fund managers reward themselves based on their performance and they have a significant portion of their assets invested alongside the client – so their interests are aligned.

Ok, that’s enough theory for this edition. There are about 12-15 different strategies hedge fund managers use. Understanding these strategies is crucial to understanding what the differences between the hedge funds are. In the next issue I am going to explain some of the strategies which hedge fund managers use. The following month I will cover the risk/reward drivers and discuss how much of your portfolio you should allocate to hedge funds.

Disclaimer: The contents of this email does not constitute financial advice. You should contact your independent financial advisor for advice relating to the content of this newsletter.

 

© Copyright, Clade Investment Management, 2007