Hedge Funds: Generating Returns in a Balanced Portfolio

Hedge Fund Manager Peregrine Capital turns 25 this year. MoneyMarketing spoke to Jacques Conradie: Chief Executive Officer and Portfolio Manager to uncover the secrets to the company’s success.

He proudly states that to generate returns better than those in the market, the company understands it has to invest and operate in a manner that is different to the average market participant. But then, Peregrine has always believed in doing things differently.

Conradie says that at the time he joined the company in 2007, the model being used by most big companies was the more senior you got, the less you interacted with the management teams of the companies you invested in. David Fraser and Clive Nates, founders of Peregrine Capital, had their own approach. They wanted the most experienced people to remain close to the companies they worked with and to continue to build long-term, proper relationships. Fraser is still with Peregrine and still loves interacting with management teams – going on site visits, talking to CEOs, doing the groundwork himself. “There’s obviously many other things you’ve got to do right, but this was one of the philosophies from the beginning,” says Conradie. “We all still cover companies, we all go to management meetings, we do all the hard work, go through company financial statements, and so on. You could probably also say it’s the discipline and work ethic to never rest on our laurels and never lose focus. Our model only exists because we perform well for clients. That must always be the north star. We have to keep delivering returns.”

Unique investment strategies

Hedge funds are known for their diverse toolsets that allow investors to generate returns in various market conditions. Unlike traditional equity or bond funds, these funds have the flexibility to employ both long and short positions, allowing them to profit from market upswings and downturns. “A big part of our job is thinking about the future and trying to visualise how the market or other fund managers will view a company in a year or two. What will that company deliver? Where will it be in several years’ time?” explains Conradie. “But the interesting thing is that it’s a lot more about common sense and figuring things out than a whole bunch of theory.”

The benefits of boutique managers

Conradie also believes that being a boutique asset manager can provide an advantage in terms of flexibility. Smaller firms can adapt quickly to market changes, adjusting their positions and asset allocation as necessary. The ability to switch between sectors, hold cash when needed, and seize opportunities in undervalued assets can help boutique hedge funds thrive. Unlike larger firms with rigid strategies, boutique managers have the freedom to tailor their approach to the prevailing market conditions, maximising their chances of success.

Wide variety of toolsets

Hedge fund managers have the freedom to express their views on the market through different investment vehicles. “We can look at the whole market and it means that in almost any economic environment, in any sector, there are times when you can do very interesting things to generate outperformance and returns for investors,” says Conradie.

They can buy or short shares based on their analysis of a company’s financials and market dynamics, or even suspicion of potential fraud. “Hedge funds can trade in futures contracts and utilise derivatives to take advantage of specific market trends or anomalies,” he says.

Diversification benefits

Diversification plays a pivotal role in generating consistent returns. By having a broad range of return generators in the fund, a hedge fund manager can ensure that even if some picks don’t perform as expected, there will still be enough winners to generate overall positive returns. By incorporating hedge funds, investors can potentially enhance their expected returns while maintaining low volatility. This combination of higher returns and reduced drawdowns is considered the holy grail of investing, providing investors with improved risk-adjusted performance.

A purist approach

Peregrine Capital famously has a Pure Hedge Fund that has never had a negative year since its inception. “It’s a combination of skill and luck, but it’s just worked out that way,” explains Conradie. “Our key ingredient is that the fund is limited to 20% net equity exposure. If the fund’s was say R100m, one example would be that you own R70m of equities, but then you must have at least R50m of shorts,” he explains. “The net of the equity longs and shorts is not allowed to be more than 20%, and that automatically limits your equity market sensitivity. It means you don’t have the normal tailwind from markets.” You’re forced to make money on the shares you own outperforming the shares you’re short. It’s a purist approach to investing!

Stock picking

Effective stock picking is the foundation of a successful hedge fund. Identifying the right stocks and avoiding poor performers is crucial. However, relying solely on a few standout stocks is risky. “I’m going to simplify, but let’s say you can find 10 different types of ideas that are going to generate outperformance for you,” says Conradie. “That’s much better than having one or two good ideas, right? Because if you have 10, if two don’t work, but five work out reasonably and three work out really well, then you still generate good returns for that year.”

Risk management and upside potential

Managing risk is a fundamental aspect of hedge fund management. The focus should be on identifying investment opportunities that offer attractive asymmetry, where the potential upside significantly outweighs the potential downside. Peregrine Capital has proved to be very successful at this with the Peregrine Capital High Growth H4Q1 Hedge Fund growing by 100 times over a period of 20 years – the first South African fund to do so. “The whole team is very proud of this achievement,” says Conradie. “It just shows how the work we’ve done for clients over an extended period has delivered.”

Contrarian thinking

Successful hedge fund managers excel at identifying long-term trends that can generate significant returns. “One of the hallmarks of successful hedge fund managers is the ability to think differently from the consensus. In the case of Capitec, a successful investment was made by recognising the company’s potential when others viewed it solely as a micro-lender,” remembers Conradie. “I met with the CEO Riaan Stassen, and I just saw something there. He and his team were so passionate. It was very different from the management teams I met at other large companies. I could see the entrepreneurial flair, and they have become an amazing success story.”