Why retirement funds should consider hedge funds

Why hedge funds?

Cora Fernandez Chief Executive, Institutional Business

Recently, falling equity markets have put hedge funds and funds of hedge funds on the agendas of many private and institutional investors. Why? Because hedge funds have an absolute-return approach and have a low correlation to traditional asset classes.

"Hedge funds have the ability to deliver investment growth when markets are performing well, while reducing the risk of capital losses during market downturns".

A powerful risk management tool

Risk management in an investment framework can come in a combination of three forms: diversification ("Don't put all your eggs in one basket"); hedging (removing the downside risk, but forsaking the full potential of the upside return) and insurance (to compensate you for loss of revenue). Hedge funds offer all three forms and aim to achieve absolute returns by balancing investment opportunities with the risk of capital losses.

"Investors are increasingly turning to hedge funds, for both absolute returns and strong risk-adjusted returns with low volatility and capital protection", Fernandez says.

Hedging against an environment of lower returns

Fundamental changes are taking place in the market, leading investors to look beyond their traditional asset allocations and strategies. Modest expected returns across a variety of asset classes, sub-par growth and a compressed outlook have left investors the challenge of how to maintain income when so many traditional sources are drying up.

Equities have become expensive (with some overpriced) now that quantitative easing has come to an end. We believe that going forward, all asset classes - be they equities or bonds - will have lower returns. Similarly, hedge funds should also have lower returns, but they should not suffer nearly as much because their returns are "uncorrelated to the market".

Positive compounding of capital

When you add an exposure to your portfolio that has a low correlation to other asset classes, a positive return expectancy as well as low volatility, you put yourself in a strong position to compound capital at attractive levels of return over the long term. High, long-term positive compounding is the result of avoiding large losses and periods of capital destruction. That's the trick. Losses destroy the rate at which capital compounds.

Smooth positive compounding of capital requires asymmetries:

Performance of S&P 500 vs HFRI Equity Hedge Index; source: Bloomberg IR&M, 2015

Hedge funds have half the volatility of equities

Hedge funds typically display half the volatility of the equity markets. So should you add a positive position to your portfolio with lower volatility, you could also minimize capital losses during market downturns. This lower volatility aspect is key. The business of hedge funds is primarily about avoiding negative compounding and protecting capital.

Steady growth in AUM

The 2014 Preqin Global Hedge Fund report states that the total AUM in the hedge fund industry have grown from USD360 billion in 2013 to USD2.6 trillion. In particular, international public sector pension funds have been steadily increasing their allocation to hedge funds over the past few years, notably from 6.9% in 2012 to 7.5% in 2013, a significant jump.

The total assets in the SA hedge fund industry is R58 billion, which has shown steady growth over the past 10 years. In the 2015 Sanlam Benchmark Survey, we found that 28% of the 60 retirement funds interviewed had invested in hedge funds with an average allocation of 2.5%.

New regulation

In 2011, the FSB introduced changes to Regulation 28 to make provision for alternative assets, where hedge funds and private equity funds were explicitly catered for, with a 10% allocation. This set the scene for improved regulation within the industry, which facilitated greater transparency and consistency across the industry, coupled with a focus on "institutional quality of service". The new hedge fund regulation from earlier this year is also bringing much greater credibility to the South African hedge fund industry.

Trustees, what now?

Locally, hedge funds have generated impressive returns over the period 2002 to 2014. For instance, the Blue Ink Long Short Aggressive Strategy Index, which tracks hedge funds with a higher equity market exposure, has outperformed the All Share Index. Overall hedge fund performance, as measured by the Blue Ink Hedge Fund Composite Index, has outperformed cash and bonds, with low levels of volatility.

Hedge Fund Performance (Blue Ink Long Short Aggressive Strategy Index, Jan 2002 – Dec 2014)

In the well-documented context of lower returns for longer, it may be time to think past traditional asset classes and incorporate alternative investments into your strategic asset allocations. Having said this, hedge fund manager selection is vital, and the performance results between managers differ widely. It is for this reason that we advocate a fund of funds approach to hedge funds.

We have witnessed one of the longest bull markets across both equities and bonds, and one needs to start thinking about hedging investments against a possible environment of lower returns to help maximise retirement outcomes.