Hedge Funds As Part Of A Balanced Portfolio

Andrew Rumbelow, Segment Head at Sanlam Investments, explains how hedge funds can be used successfully as part of a client’s overall pension fund solution.

Hedge funds provide important diversification benefits within a portfolio. The revised Regulation 28 of the Pension Funds Act allows retirement funds to invest up to 10% of their investment in hedge funds. Yet take up among South African pension funds remains low. To help make sense of hedge funds and the benefits they offer pension fund members, here are some pointers:

What is a hedge fund?

Hedge funds are investment portfolios managed by some of the brightest minds in the industry.  They are similar to unit trusts in that these strategies look to exploit return opportunities in equities, bonds and cash markets.

However, they differ in some very important ways:

• Hedge funds are not regulated in the same way as unit trusts. While the hedge fund managers are regulated, the investments themselves aren’t, and therefore hedge funds have the flexibility to do things normal funds can’t.
•  As a result, the investment strategies they use are different from those used by typical funds. Typical funds are long-only, which means they buy and hold shares and bonds. In addition to buying assets, hedge funds can sell shares they don’t own (short selling) and borrow money to invest (gearing).  They can also use derivatives extensively and exploit market inefficiencies through arbitrage strategies (when the same asset is sold at different prices in different markets).

 Because of the investment freedom hedge funds enjoy, they can invest in a wider range of instruments than traditional investments. Their ability to sell stocks short and use derivatives means that they are able to manage risk more effectively.

Some hedge funds pursue aggressive strategies and can take on substantial risk while pursuing high returns, while most may have a risk profile equal to or even lower than the typical long-only fund, and aim to provide stable real returns that display a low correlation to the rest of the market.

Therefore it is important to understand the specific hedge fund you invest in and select a trusted manager.

Diversification benefits

A number of international academic studies have shown that the overall risk/return characteristics of a diversified portfolio improves when hedge funds are included as part of a balanced portfolio (Schneeweis, Karava, Georgiev, 2002).

In addition, the leaders in asset-liability management, the US university endowment funds, have consistently increased their allocation to alternatives and, in particular, hedge funds over the last 10 years. They cite the predictability of returns and consistency of alpha as the main considerations.

Local academic research and empirical evidence mirrors the international experience. Domestic hedge fund returns have been impressive and their inclusion in a domestic balanced portfolio has had a greater impact than in the international experience.

Source: BlueInk Investments. The Blue Ink SA Hedge Fund Composite represents the average manager net of fees.

Our preference, especially from the multi-manager perspective, is to use hedge funds as a risk management tool and not as a return-seeking vehicle. The resulting return profile exhibits a low correlation to traditional investments and provides a source of additional returns.

By combining hedge funds with traditional investments, we are able to reduce the overall risk of multi-managed funds while congruently adding an additional source of returns, thus providing an overall superior investment experience to investors.

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