Long- and Short-Run Dynamics between South African Hedge Funds and the Equity Market

Abstract

The hedge fund industry in South Africa has undergone positive changes in terms of both regulation and structure since 2007. These changes have provided an opportunity to further utilize hedge fund strategies within a portfolio management framework. This is especially significant when considering the diversification potential that hedge funds may have and their ability to generate an alternative source of return, both of which are important when considering tactical and strategic asset allocations. There is therefore a need to model the interrelationships between the major hedge fund strategies and the local equity market in order to understand the dynamic linkages that may be present in both the long and short term. We conducted cointegration analysis within the VAR framework on monthly data spanning from 2007 to 2018. The analysis of long-term dynamics indicated that there is no cointegration between the All Share Total Return Index and the hedge fund strategy return indexes as measured under a Johansen cointegration methodology. Pairwise Granger causality tests supported the cointegration findings with no directional causal impacts found. The analysis of short-term dynamics via impulse responses indicated limited causality between the hedge fund indexes and the equity market, while variance decomposition showed few spill-over effects from the equity market to the hedge fund indexes. The overall findings imply that a South African investor could achieve diversification benefits in both the short and long term by adding hedge funds to an equity-centric portfolio. The findings also provide evidence that hedge funds can be used as effective components within tactical and strategic asset allocation. <b>TOPICS:</b>Real assets/alternative investments/private equity, emerging markets, risk management, VAR and use of alternative risk measures of trading risk, quantitative methods, statistical methods <b>Key Findings</b> ▪ There is no long-term equilibrium relationship between the returns of South African domiciled hedge funds and the equity market. This is supported by both cointegration and Granger causality analyses. ▪ Hedge funds provide investors with diversification benefits in both the short and long term when added to an equity-centric portfolio. ▪ The results support the use of hedge funds in both tactical and strategic asset allocation.