Hedge funds offers good protection against equity market risk

"Most investors with a longer term horizon need equities as a core building block in their portfolios. Equities however, introduce downside risk, as markets have shown. Some hedge fund strategies like equity hedge incorporate investment views that are not dependent on the direction of the equity market to produce a return. As a result, this differentiated source of return complements the portfolio's long only (buy-and-hold) equity portion that is dependent on the direction of the market," she said.

Other hedge fund strategies, like fixed interest arbitrage, also provide asset class diversification without necessarily taking a directional view on interest rates - making them a potentially good fit with the bond portion of a portfolio.

Thorough understanding is necessary

"Hedge funds should be considered to protect portfolios against extended drawdown periods, while still participating meaningfully in the upside and outperforming cash. When approached prudently, investing in hedge funds enables investors to avoid negative compounding by withstanding downside risk," De Waal added.

She cautioned, however, that a thorough understanding of the hedge fund strategies to be included in the portfolio is necessary to efficiently blend investment strategies to achieve risk diversification.

De Waal said that South African hedge funds offer good disclosure, with funds of hedge funds having been instrumental in establishing reporting standards by local hedge funds that surpass those of their global peers. Transparency into portfolio holdings makes it easy to monitor mandate compliance, track performance and check risk exposures.