Why retirement funds should consider allocating to hedge funds

Boosting retirement outcomes in a low-return environment: Part 2

Hedge funds are a powerful lever for retirement funds to diversify, spread their risk and enhance returns within the ambit of Regulation 28, says Cora Fernandez, Chief Executive Officer at Sanlam Investments (SI) Institutional Business. Hedge funds don’t need a bull market to generate attractive returns; they can show solid returns in bear markets because they can short the market, she says.

In Part Two of this series, we look at why trustees should consider alternative asset classes, such as hedge funds, in their strategic asset allocation deliberations.

Hedge funds in their most basic form are designed to be closest to purist opportunistic investments. Given their increased toolkit in terms of instruments available, these strategies have the ability to deliver investment growth in various market environments. This wider investment universe allows hedge funds to provide investment growth when markets are performing well, while reducing the risk of capital loss in periods of market stress. We often term this as the asymmetry of returns.

Why hedge funds?

A powerful risk management tool
Risk management in an investment framework can come in a combination of three forms; diversification, hedging and insurance. This can be explained by a simple parable, one of an egg farmer trying to sell her eggs in the markets. The egg farmer is worried about the risk of her eggs breaking on her trip to the market.

She could:
1) Diversify: Pack her eggs in several baskets. That is, if one basket falls she still has others to sell. Remember, “Don’t put all your eggs in one basket”.

2) Hedge her bets: Stay at home. This way she is guaranteed of not breaking her eggs on her way to the market. The cost, though, is not being able to sell her eggs. This is the concept of hedging. You remove the downside risk, but forsake the full potential of the upside return.

3) Consider insurance: Get a third party to provide insurance to compensate the farmer for loss of revenue if her eggs break. An insurance premium will need to be paid, however the risk is lessened.

So how does this story about the egg farmer relate to hedge funds?
Hedge funds aim to achieve absolute returns by balancing investment opportunities with the risk of capital losses. Given their increased toolkit, they provide all of the above required risk management offerings; diversification, hedging (eg: buying
and selling futures) and insurance (eg: buying derivatives such as put options). A number of international academic studies have shown that the overall risk/return characteristics of a well-balanced and diversified investment portfolio improve when hedge funds are included in a portfolio (Schneeweis, Karava, Georgiev, 2002). In addition, many US endowments have been increasing their allocation to alternatives and, in particular, hedge funds over the last ten years. They cite the predictability of returns and consistency of alpha as the main considerations. Local research mirrors the international experience too. Domestic hedge fund returns have been impressive and their inclusion in a domestic balanced portfolio had a significant impact during the 2008/2009 global financial crisis.

Locally, many investors started to look to hedge funds as a viable investment when markets peaked in 2000. More 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.

“Investors are increasingly turning to hedge funds, for more than just absolute returns but also for strong risk-adjusted returns with low volatility and capital protection”, Fernandez says.

Hedging against an environment of lower returns
Since the credit crisis, equities have enjoyed a meteoric rise, thanks in part to the US Fed’s quantitative easing (QE) policies. Now, if we look forward, primarily because risk premiums have become compressed, valuations are more stretched (equities are expensive, and some overpriced) and quantitative easing is coming to an end. Our base case view is 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
Given that hedge funds tend to have lower betas and lower correlation to equities, debt, and other asset classes, we believe that when you add an exposure to your portfolio that has low correlation, 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.

The S&P 500 Index, with dividends reinvested, has compounded at a rate of 4.2% for the 15-year period from 2000 to 2014 (source: Ineichen Research & Management, May 2015). The average hedge fund portfolio, net of fees, has compounded capital at a rate of 5.8% over this period. This is a big difference; how did they do it?

Quite simply, you should own investments that compound positively, thereby avoiding those that compound negatively. The trick to a higher rate of compounding capital is not to lose it. The hedge fund business is as much about avoiding negative compounding as it is about embracing positive compounding. 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.”

Hedge funds have half the volatility of equities
If we look at the volatility characteristics of hedge funds, they 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.

“We often say that the worst thing about hedge funds is the name itself.”

Why the negative bias = myths and perceptions?
We often say that the worst thing about hedge funds is the name itself, “hedge funds”. The high-profile, headline-grabbing scandals that have previously plagued the industry are unfortunately the first thing that come to mind when you hear ‘hedge funds’. Like most industries, you will have a few bad actors, and the hedge fund industry is no different, says Fernandez. That is why we welcome the increased regulatory oversight and enhanced compliance requirements for the industry, as it helps with rooting out these “bad actors”. The industry has evolved significantly from its pre-crisis structure, where the “small rock band look-alikes” have made way for the bigger institutionalised players.

“Institutionalisation of hedge funds adds impetus”

It is pleasing to see that locally, and to a much great extent globally, investors have moved beyond the headlines – as evidenced by the sheer size and growth of the industry. The numbers paint a very different picture to the headlines that grabbed our attention both pre- and post the financial crisis. The 2014 Preqin Global Hedge Fund report states that the total assets in the hedge fund industry grew by USD360 billion in 2013, taking the total assets under management to USD2.6 trillion. The survey also found that investors are increasingly turning to hedge funds as a source of strong risk-adjusted returns with low volatility – consistently. 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 under management in the South African hedge fund industry is R58 billion, which has shown steady growth over the past 10 years, since inception in the hedge fund industry in the local market. 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%.

Traditionally, hedge funds have been poorly understood, especially when compared with the level of understanding and related communication of traditional asset classes and managers. The tools, processes and systems used in hedge fund management selection, monitoring and reporting have been restricted to very few specialist players. However, the scales started to tip in their favour in 2011, when National Treasury and the Financial Services Board 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 amendment 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”. We have welcomed these regulatory interventions, because they protect the industry from “rogue elements”. However, despite the persisting perception that hedge funds are ‘risky’, we believe that these myths are slowly being dispelled, and the new hedge fund regulation is bringing much greater credibility to the South African hedge fund industry. Hedge fund investors can now enjoy greater protection and transparency.

Trustees, what now?
Until now, institutional investors have felt that the challenges of navigating the hedge fund world were just too daunting, and given the strong performance of other asset classes up until now, the effort associated with including hedge funds in portfolios did not seem to justify the incremental returns and diversification benefits associated with hedge funds.

However, in this lower return environment, every basis point counts and it may be time to revisit the reasons for not considering hedge funds in your strategic asset allocation decision. The attractive returns and diversification benefits may very well have improved, thereby enhancing the “return on effort” of investigating hedge funds.

Locally, hedge funds have generated impressive returns over the period 2002 to 2014 and their inclusion in a domestic balanced portfolio has had an even greater impact than on the international front. Having said this, manager selection in the hedge fund industry is vital, and the performance results between managers differ widely.

In conclusion, in the well-documented context of lower returns for longer, isn’t it time to think past the traditional asset classes and incorporate alternative investments into your strategic asset allocation? 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. Get in touch with us to discuss the possibilities.

Disclaimer
Sanlam Investment Management (Pty) Ltd (“SIM”) is an authorised Financial Services Provider. This publication is intended for information purposes only and the information in it does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Although all reasonable steps have been taken to ensure the information in this document is accurate, SIM does not accept any responsibility for any claim, damages, loss or expense, however it arises, out of or in connection with the information in this document. Please note that past performances are not necessarily an accurate determination of future performances and the performance of a fund depends on the underlying assets and variable market factors. International investments or investments in foreign securities could be accompanied by additional risks, such as potential constraints on liquidity and the repatriation of funds, macroeconomic risk, political risk, foreign exchange risk, tax risk and settlement risk, as well as potential limitations on the availability of market information. Independent professional financial advice should always be sought before making an investment decision.

Sanlam Life Assurance Company (Ltd) is a licensed financial services provider.