Despite its obvious attraction during periods of market volatility and downturns, the newly regulated local hedge fund industry, which is now open to retail investors, is unlikely to see an immediate deluge of inflows. But expect the charm offensive to begin soon.The long-short strategy dominates in rand-denominated hedge fund portfolios, with just over 60% of assets controlled in this way.This means fund managers buy into long positions in companies they believe will deliver growth over time, while simultaneously shorting other instruments by betting their value will fall over the short term.The result of this dual exploitation of mispricing is effectively an ability to deliver positive returns even through market downturns.The Association for Savings and Investment South Africa is backing the use of hedge funds for pension funds and retail investor savings as part of a blend of products for retirement.Leon Campher, Asisa CEO, said index tracker funds, active fund management and hedge funds all had a role to play in pre-retirement accumulation for the country's employees.But investors needed to be educated about their use.Robert Foster, convener of the Asisa hedge fund standing committee, said the newly regulated local hedge fund industry grew its assets under management by R5.1-billion in 2015.With total assets under management of R62.1-billion, this paled in comparison with more traditional collective investment schemes such as unit trusts, which together boasted nearly R2-trillion under management.Part of the challenge hedge funds faced in finding customers in South Africa was the decades-long track record of success of the local unit trust industry, which now boasted more than 1300 products.Nevertheless, he said, the industry had grown steadily since 2011, when retirement funds were allowed to invest a portion of their assets in hedge funds.In April 2015, South Africa became the first country to introduce comprehensive hedge fund product regulation, bringing them under the umbrella of the Collective Investment Schemes Control Act.The first two approved managers and their funds, which represent 70% of the industry, were given the green light in December 2015 and launched this month. Foster said between 70 and 100 hedge funds had been given approval to date.There are two classes of Cisca-approved hedge funds - qualified investor funds, which have a minimum investment threshold of R1-million, and retail investor hedge funds, which are more closely regulated in terms of strategy."There are limits on the size of the position a retail investor hedge fund can take in a single share or instrument ... Leverage is capped at 200% of the portfolio value," Foster said.These measures would not materially affect providers' appetite for offering hedge fund products, since Asisa's analysis showed that the majority of assets under management in the local hedge fund space could be managed within these limits."Generally, we have a low level of leverage and more conservative approach employed by local fund managers, compared with their US counterparts." Leverage is the use of borrowed capital by the fund manager.The largest hedge fund players in South Africa are 36ONE, Visio and Capricorn."Good managers are attracting the assets. That's normal," Foster said. More than a third of hedge fund managers in the country had more than 10 years' experience in hedge funds.According to the HedgeNews Africa Long/Short Equity Index, the local industry delivered a performance of 17.1% for the year to the end of December 2015, 15.1% over five years and 14.5% over seven years.By comparison, Asisa's figures showed, the JSE All Share Index achieved a 5.1% return for the 12 months ended December 2015, 13% for the five years and 16.4% over seven years. The South African multi-asset medium equity category recorded average returns of 7.4% for the one year to the end of December 2015, 10.6% for five years and 11.3% for seven years.Foster said this showed the value of hedge funds during tough market conditions.Would a burgeoning hedge fund industry begin to have an effect on market pricing?According to a 2014 Federal Reserve board study, US hedge funds tended to make market pricing more efficient and less volatile until liquidity dried up and their reliance on short-term funding led to asset sales at exaggerated low prices.Foster said the regulation was intended to encourage the free flow of information from product providers to the regulator, which would enable the Financial Services Board to spot disturbing trends in time."The industry has to report regularly at instrument and share level. While qualified investor funds don't have any limits in place, retail funds cannot overindulge in one share, manager or fund. Hedge funds in general tend to resist herding behaviour, unlike indexation."Foster said even qualified investor hedge funds needed their mandates approved by the Financial Services Board."I doubt a proposition like unlimited leverage would pass muster. The FSB applies a reasonability test."Discovering true value fasterNico Smuts, investment analyst at 36ONE Asset Management, said hedge funds tended to trade more frequently than traditional long-only funds such as unit trusts."All else being equal, an increase in the popularity of hedge funds should contribute to a more efficient stock market."If a larger proportion of locally listed assets was to be controlled by hedge funds, said Smuts, the proportion of short-selling should also increase. "In a market without short sellers, there is only one party who can bring down the price of an overvalued share: the holder of the share who wishes to sell it. In such a market, overvalued companies can take a long time to revert to fair value, particularly if few of the holders are willing to sell."Short-selling introduces a second party: those who do not hold the share but believe it is overvalued and thus wish to sell it short."This made the "price discovery process more efficient, particularly for overvalued shares", Smuts said.To limit exaggerated movements, the JSE prohibits "naked" shorting - the practice of short-selling stock without first at least borrowing the security.Those wanting to short a share "must borrow the share from a current shareholder. This ensures that short-sellers cannot create undue selling pressure by overwhelming buyers in the market."Smuts said the investment strategies of local hedge funds, which employ low to moderate leverage, posed little to no systemic risk to the market."Examples of meaningful market distortions come predominantly from the US, where excessive leverage led to the $3.6-billion bailout of Long Term Capital Management in 1998."Although some high-frequency trading funds transact on the JSE, most keep a low profile and are managed out of the US and Europe, "so we have limited insight into their size and behaviour".peacockb@sundaytimes.co.za..