"Changes to Regulation 28 of the Pension Funds Act mean that hedge funds can be used to a much greater extent as a differentiating source of income in retirement funds - both for younger investors who want real returns, and for retired investors who focus on a steady, inflation beating income," says Marius Kilian, CEO of Novare Investments.
Kilian added that portfolio diversification to manage the risk of return volatility had proved its worth over recent years when many investors had been humbled by uncertainty and erratic markets. Hedge funds should be considered in the context of the total portfolio, and as a complement to traditional asset classes rather than a replacement.
Diversification is a powerful strategy to manage the risk of return volatility, allowing investors to establish portfolios that are consistent with their unique goals and preferences. Through diversification investors seek to minimise the risk of large portfolio draw-downs. Volatility and large draw-downs negatively impact the total performance of a portfolio.
"Hedging is a technique to reduce overall risk in a portfolio by taking a position that offsets other existing sources of risk. Hedge funds should not be seen as agents for supersizing returns, but as investment options that offer risk and return opportunities not commonly found in traditional long only stock and bond investments," says Kilian.
"Because a portfolio's risk is less than the sum of the risks of its individual assets, the real risk and return benefits of a particular hedge fund have less to do with its own stand alone performance than with how it performs relative to an investor's existing portfolio. Hedge funds are used as a differentiated source of return in the context of meeting long-term needs pre- and post-retirement. They have delivered superior risk adjusted returns over time and their inclusion in a portfolio enhances its return and risk characteristics."
Kilian noted that hedge funds are sometimes considered a single and coherent asset class, which is incorrect because they represent a set of diverse investment strategies. Each strategy has unique risk and reward characteristics and a different correlation relative to traditional asset classes. "The key is to gain an understanding of how the particular hedge fund is correlated to the rest of the portfolio in the context of a differentiated source of return."
